CFP Investment Planning

David has won the Illinois state lottery. He must decide whether to receive annual payments of $250,000 at the beginning of each year for the next 20 years, or a lump sum payout. What lump sum amount does David need to receive to equal the $250,000 payments for the next 20 years, if he can earn an 8% return on his investments, assuming inflation is 3%?

$2,650,900. This is a present value of an annuity due problem. So... N = 20 I = 8 PV = ? PMT = 250,000 FV = 0. Put your calculator in BEGIN mode and solve for PV. Inflation is not necessary in this calculation, lotto winnings income streams will not increase for inflation, they are the equivalent to a fixed annuity.

Cathy and John Gonnerman would like to retire in twelve years. At that time, they would like to have accumulated $350,000 in today's dollars. To achieve this goal, they plan to invest a sum at the end of each year that will remain constant in purchasing power. They anticipate average inflation at 6% and have an after tax investment earning capacity of 9%. What payment is required at the end of the first year for them to reach their goal?

$26,394.63 The payments increasing each year will keep pace with inflation at the end of 12 years. N = 12 i = [(1.09/1.06)-1] × 100 = 2.83 PMT = 24,900 × 1.06 = 26,394 FV=350,000 Since the payment you solved for is made at the end of the period (one year from today), we need to account for the year of inflation before we make the first payment. The calculator inflates from the first payment forward, it does not account for the time between today and the first payment. Further information to verify the above calculation: $350,000 today, inflated at 6%, is equal to 704,269 in 12 years. PV = 350,000 N = 12 I = 6 solve for FV = $704,269 Solve for the serial payment amount: N = 12 I = (1.09/1.06) - 1 × 100 FV = 350,000 NOTE: the inflation is being accounted for in the PMT solve for PMT = $24,900.59 since the first payment is not being made until the end of the year, you have to multiply by (1 + inflation rate) because you have to "make up" for the first year of inflation 24,900.59 × 1.06 = 26,394.63

Charles Cornwall needs an income stream equivalent to $30,000 in today's dollars at the beginning of each year for the next 12 years to maintain his standard of living. He assumes inflation will average 5% over the long run and that he can earn a 7% compound annual after tax return on investments. What lump sum does Charles need to invest today to fund his needs?

$325,202.39 BEGIN Mode N = 12 i = [(1.07/1.05) - 1] × 100 = 1.9048 PV = ? PMT = 30,000 FV = 0

Billy Smith, age 55, has been a member of the union for 30 years, and as a result, has been excluded from his employer's retirement plan. Billy has been offered a management position with his firm, which will make him eligible to participate in the company's 401(k) plan. Billy's objective is to retire at age 65 with $2,000 in monthly retirement income, exclusive of Social Security benefits. He assumes a life expectancy of age 95. The union retirement plan will provide him with $1,000 monthly. (There are NO matching contributions from Billy's employer to the 401(k) plan and his income is adequate to have the required level of contributions fall within the deferral limits of the 401(k) plan. Contributions and payments, as appropriate, are made at the beginning of each month.) If the return in the company's 401(k) plan is 10%, what monthly amount will Billy have to contribute to that plan for 10 years to meet his objective?

$556 This question is intended to test several time-value-of-money calculations, and is NOT intended to imply a level retirement income or savings approach. Set calculator on "BEGIN" mode. N = 30 × 12 = 360; i = 10 / 12 = .8333; PV = ?; PMT = 1000; FV = 0. Solve for PV of annuity due ($114,900). Then use the PVAD (stay in BEGIN mode) figure of 114,900 as a FV, where N = 10 × 12 = 120; i = 10 / 12 = .833; PMT = ?; FV = 114,900; Answer for payment = $556.

*Equipment Trust Certificate

*An equipment trust certificate (ETC) refers to a debt instrument that allows a company to take possession of and enjoy the use of an asset while paying for it over time. The debt issue is secured by the equipment or physical asset. During this time, the title for the equipment is held in trust for the holders of the issue.

*Estimating Bond Price

*Duration can also be used to estimate the price change of a bond, based upon a change in interest rates. EXAM TIP: this is on your CFP formula sheet.

*Mortgage-Backed Securities

*Government National Mortgage Association (GNMA or Ginnie Mae): - Consists of a pool of Farmers Home Administration (FHA)/VA guaranteed mortgages. Each month, GNMA distributes interest and principal payments to investors. *The interest component is subject to both state and federal income tax, the component that is return of principal is not taxable. They are backed by the full faith, credit and taxing power of the U.S. government. The government backs the issue against default, NOT against investor loss through poor timing or poor choices. The amount received by the investor each month may vary due to prepayment by homeowners. The realized yield on the certificates can be somewhat variable because of the principal prepayments. If mortgage rates decrease, prepayments may increase. Federal National Mortgage Association (FNMA or Fannie Mae) and Federal Home Loan Mortgage Corporation (FHLMC - Freddie Mac): - Historically not backed by the U.S. government. FHFA helped bail them out in 2008. The biggest risk with mortgage-backed securities is falling interest rates. Mortgages could get repaid early (repayment risk), and the bond gets retired early, which leaves investors with a reinvestment problem. Risks to MBSs that can be difficult to determine: - Actual maturity is not known with certainty. - Actual cash flows are not known with certainty.

*Firm Commitment Underwriting

*The underwriter agrees to buy the entire issuance of stock from the company. The underwriter may buy the stock from the company for $18 a share and sell it to the public for $20 a share, thus making the spread. The risk that an issuance may not sell resides with the underwriter.

*Barbells (Bond Strategy)

- A barbell strategy involves owning both very short-term and very long-term bonds, with very few intermediate-term bonds. - When interest rates move, only one set of positions needs to be sold and restructured.

Call Options

- A call option is the right to BUY a specified number of shares at a specified price (strike or exercise price) within a specified period of time (American options) or at a specified future date (European options). - Buyers of call options believe the price of the underlying stock will RISE, sellers believe the price of the underlying stock will FALL or STAY THE SAME. EXAM TIP: Anytime the CFP exam asks which option will provide the investor with the maximum gains if the stock price appreciates, the right answer is "Buying a Call."

Collateral Trust Bonds (Secured Bond)

- A collateral trust bond is backed by an asset owned by the company issuing the bonds. - The asset is held in a trust by a third party. - In the event of a default on the debt payment, the bondholders are entitled to the asset being held in the trust.

Book Value

- A firm's book value represents the amount of stockholder's equity in the firm or how much the company's shareholders would receive if the firm was liquidated. - The book value per share is useful to compare to the firm's stock price. - If the stock price is significantly higher than the firm's book value, it may indicate that the firm is overvalued. If the book value per share is equal to or higher than the firm's stock price, it may indicate the firm is undervalued.

*Laddered Bonds (Bond Strategy)

- A laddered bond portfolio requires purchasing bonds with varying maturities. - As bonds mature, new bonds are purchased with longer maturities than what is outstanding in the portfolio. - This strategy helps REDUCE INTEREST RATE RISK because bonds are held until maturity.

Put Options

- A put option is the right to SELL a specified number of shares at a specified price (strike or exercise price) within a specified period of time (American options) or at a specified future date (European options). - Buyers of put options believe the price of the underlying stock will FALL, sellers believe the price of the underlying stock will RISE or STAY THE SAME. EXAM TIP: if the CFP exam asks about maximizing gains if the stock price falls, the right answer is "Buying a Put."

Treynor Index

- A risk-adjusted performance measure. It's also a "relative" risk-adjusted performance indicator, meaning one Treynor ratio needs to be compared to another Treynor ratio to provide meaning. - A measure of how much return was achieved for each unit of risk. The higher the Treynor ratio, the better because that means more return was provided for each unit of risk. - It measures the reward achieved relative to the level of systematic risk (as defined by beta). - Accomplished by standardizing portfolio returns for volatility. - Treynor justifies the use of the model on the assumption that in a well-diversified portfolio, the unsystematic risk is already close to zero. - It doesn't indicate whether a portfolio manager has outperformed or underperformed the market. - Uses the beta of a portfolio as its denominator and the difference between the portfolio return and the risk-free return as the numerator. NOTE: both Treynor and Alpha use Beta as the measure of risk; therefore, Treynor and Alpha are appropriate risk-adjusted performance indicators when considering a diversified portfolio. A portfolio is considered diversified when r-squared is greater than or equal to 0.70. If the r-squared is less than 0.70, then it is not well diversified and Sharpe should be used because standard deviation is an appropriate measure of risk.

*A Share Mutual Funds

- A shares have a front-end load (up front sales commission). - Small 12b-1 fee, which is the marketing fee used to pay distribution expenses (known better as "trailing commissions."). - No redemption fee or back-end load. - A shares are appropriate for long-term investors because of the low 12b-1 fees.

*Tax Swap (Bond Strategy)

- A tax swap involves selling a bond that has a gain and a bond that has a loss to offset each other. - A tax swap also involves selling a bond that has a loss position and just buying a new bond.

Dollar Cost Averaging

- Allows an investor to invest the same dollar amount on a periodic basis, typically monthly. - By investing the same dollar amount each month, an investor buys fewer shares when the price increases and more shares when the price decreases.

*Semi-Strong Form of the Efficient Market Hypothesis

- Asserts that all public information is reflected in prices. - Both historical and public information will not help investors achieve above-average market returns. - The semi-strong theory REJECTS BOTH technical and fundamental analysis, but inside information will lead to above-average market returns. Summary: - Price reflects: public information. - Advantage through: inside information. NOTE: all three forms suggest that technical analysis will not help you achieve above-average market returns.

Arbitrage Pricing Theory (APT)

- Asserts that pricing imbalances cannot exist for any significant period of time; otherwise investors will exploit the price imbalance until the market prices are back to equilibrium. - APT is a multi-factor model that attempts to explain return based on factors. Anytime a factor is a value of zero, then the factor has no impact on return. - APT attempts to take advantage of price imbalances. - Inputs are factors (F) such as inflation, risk premium, and expected returns and their sensitivity (b) to those factors. - STANDARD DEVIATION and BETA are NOT INPUTS variables to the APT. EXAM TIP: you don't need to memorize the formula, but you should know the keywords: multi-factor model, sensitivity to those factors, and STD and Beta are not inputs.

U.S. Treasury Bonds

- Bonds have a maturity greater than 10 years. - Interest is paid semi-annually.

Series HH/Series H Bonds

- Bonds that pay interest semiannually. - Series HH bonds have not been issued since August 2004.

Bullets (Bond Strategy)

- Bullet strategies have very little payment during the interim period and then a lump sum at some specified date in the future. - Most of the bonds in this strategy will mature in or around the same time period. - Zero-coupon bonds, treasuries, and corporates are the most likely candidates for a Bullet strategy since they pay little or no coupon during the period, and the payoff comes at some predetermined date in the future. - Bullet strategies are typically used when the investor has a balloon payment due on a liability at some future date.

Dollar-Weighted Return

- Calculates IRR using the INVESTOR's cash flows. - This calculation would take into account additional share purchases, as it is looking for investor return.

*Time-Weighted Return

- Calculates IRR using the SECURITIY's cash flow. Assumes a buy and hold. - This calculation would not take into account additional share purchases. It is concerned with the growth of a share or single purchase, since it is concerned with the securities cash flow, not the investor. - Determined without regard to the investor's cash flows. - Mutual funds report a time-weighted return basis. EXAM TIP: you may not have to calculate dollar-weighted or time-weighted return, but you must know that mutual funds report on a time-weighted basis.

Charting (Tools of Technicians)

- Charting involves plotting of historical stock prices to determine trading pattern. - Charting also involves plotting a 50-, 100-, or 200-day moving average along with the historical stock prices.

*Coefficient of Variation

- Coefficient of variation is useful in determining which investment has more relative risk when investments have different average returns. - It tells us the probability of actually experiencing a return close to the average return. - The higher the coefficient of variation, the more risky an investment per unit of return. - Standardizes the measure of risk per unit of return. - See example on p. 21 of Investment Planning book. CV = Standard Deviation / Average Return EXAM TIP: the asset with the lower CV (risk/return) has the higher Risk-Adjusted Return (return/risk) because there is less variation around that average.

*Types of Futures Contracts

- Commodity Future Contracts where the underlying asset is copper, wheat, pork bellies or oil. - Financial Future Contracts where the underlying asset is currency, interest rates and stock indices. - The two primary players in the futures markets are hedgers and speculators. - Futures contracts are "marked to market." The gain or loss (in cash) is credited/debited to your account on a daily basis. Characteristics of Futures Contracts: - Buyer agrees today to pay for and take delivery of (and the seller agrees today to make delivery of) a commodity on a specific date in the future. - The price is agreed to today. - The quality and quantity of the commodity is agreed to today. - The delivery date is agreed to today. - Futures may be held until delivery date (which occurs for < 1% of contracts) or traded on a futures exchange. - All trading is done on a margin basis. *Long hedge position: The investor is short the underlying commodity and long the futures contract.

Convertible Bonds

- Conversion value is the value of the convertible bond in terms of the stock into which it can be converted. - One of the primary benefits of convertible bonds is that even if the stock does not perform well, the investor has the floor built in. The floor is the par value of the bond that the investor will receive if the convertible bond is held to maturity. CV = (PAR / CP) x Ps - Ps = the price of the common stock. - CP = the conversion price. - (1,000 / CP) = the conversion ratio or the number of shares the convertible can be converted into. EXAM TIP: this formula is no longer on the CFP formula sheet.

*Correlation/Correlation Coefficient

- Correlation and the covariance measure movement of one security relative to that of another. - Covariance and correlation coefficient are both relative measures. - Correlation ranges from +1 to -1 and provides the investor with insight as to the strength and direction two assets move relative to each other. - A correlation of +1 denotes that two assets are perfectly positively correlated. - A correlation of 0 denotes that assets are completely uncorrelated. - A correlation of -1 denotes a perfectly negative correlation. - Diversification benefits (risk is reduced) BEGIN anytime correlation is less than +1. - This is not a provided formula (see formula on p. 24 of Investment Planning). It is the algebraic equivalent of the Covariance formula (provided). EXAM TIP: you won't have to calculate correlation using the formula, but you need a thorough understanding of the concepts related to correlation.

*Debentures (Unsecured Corporate Bonds)

- Debentures are simply unsecured debt that is not backed by any asset. - Debentures are backed by the belief in the creditworthiness that the issuing company (or government) will repay the debt.

Corporate Bond Risk

- Default risk - Reinvestment rate risk - Interest rate risk - Purchasing power risk EXAM TIP: The primary difference between Corporate Bond Risk and US Government Bond Risk is that US government bonds are not subject to default risk. Muni bonds can be considered to have default risk unless they are insured.

*Property Valuation

- Determines how much an investor is willing to pay for a piece of property. - The formula is really just a restatement of the dividend yield formula where you are determining how much an investor is willing to pay for a stock, or in this case, real estate. Capitalized Value = Net Operating Income (NOI) / Capitalization Rate Capitalized Rate = NOI / Cost Calculating NOI: Gross Rental Receipts + Non-Rental Income = Potential Gross Income (PGI) - Vacancy & Collection Losses = Effective Gross Income (EGI) - Total Expenses = Net Income + Interest Expense + Depreciation Expense = Net Operating Income Cash operating expenses does NOT include depreciation or amortization, which are not cash expenses. It also excludes payments on debt service since this is a financing expense, not an operating one. EXAM TIP: Know how to calculate NOI. Simply take net income and add back depreciation and financing activities. In other words: NOI = Gross income - Operating expenses See example on p. 110 of investment planning book.

*Modern Portfolio Theory (MPT)

- Developed by Harry Markowitz. - The acceptance by an investor of a given level of risk while maximizing expected return objectives. - Investors seek the highest return attainable at any level of risk. - Investors want the lowest level of risk at any level of return. - The assumption is also made that investors are risk averse. *NOTE that negatively correlated assets are NOT necessary to reduce the risk of portfolios. Correlation of anything less than 1 helps to reduce the risk of a portfolio.

Duration Assumptions

- Duration assumes that there is a linear relationship between a change in interest rates and a bond's price change. - In fact, the actual price change of a bond is NOT linear; it's curve-linear. *- Convexity is a concept that actually measures the difference in price between what duration estimates and the actual price change of a bond. - Duration does a good job of estimating the price change of a bond for small changes in the interest rates. - Duration does NOT do a good job of estimating the price change of a bond for large changes in interest rates. - Duration understates the price appreciation when interest rates decrease. - Duration overstates the price depreciation when interest rates increase.

*Bond Duration (Macaulay Duration)

- Duration is the time-weighted average maturity of all cash flows. The weight of each cash flow is determined by dividing the present value of the cash flow by the price. *- The longer the duration, the more price sensitive or volatile the bond is to interest rate changes. In simple terms, the faster I get it, the more I like it. - Macaulay duration is frequently used by portfolio managers who use an immunization strategy. Duration is the moment in time the investor is immunized from interest rate risk and reinvestment rate risk. - In other words, to immunize a portfolio, the duration must equal the time horizon. - If an investor expects interest rates to INCREASE, the bond with the smallest duration will be the least sensitive to changes in interest rates. The bond with the smallest duration will have the shortest term and the highest coupon/YTM. - If an investor expects interest rates to DECREASE, the bigger duration of a bond, the more sensitive to changes in interest rates. By choosing the bond with the biggest duration, an investor will experience the biggest capital gain. The bond with the longest term and smallest coupon/YTM. - Modified duration is a bond's price sensitivity to changes in interest rates. In other words, it provides a measure of a bond's volatility. - A bond portfolio should have a duration equal to the investor's time horizon to be effectively immunized. In other words, the portfolio's AVERAGE WEIGHTED DURATION should match the investment horizon. EXAM TIP: Know this flashcard. Additional EXAM TIP: there's an INverse relationship between coupon/YTM (which are INterest rates) and duration.

Off-Budget Debt of the Agencies

- Federal National Mortgage Association (FNMA - Fannie Mae) - Federal Home Loan Mortgage Corporation (FHLMC - Freddie Mac) - Student Loan Marketing Association (SLMA - Sallie Mae) - Federal Farm Credit Banks (FFBC) - Federal Intermediate Credit Banks (FICB) - Federal Home Loan Bank (FHLB)

Market Volume (Tools of Technicians)

- Gives technicians insight into investor sentiment. - If market volume is high and the market goes up, that's a positive indicator regarding investor sentiment. - If market volume is high and the market goes down, that's a negative indicator regarding investor sentiment. - If market volume is low and the market goes up, that's a negative indicator regarding investor sentiment. - If market volume is low and the market goes down, that's a positive indicator regarding investor sentiment.

On-Budget Debt

- Government National Mortgage Association (GNMA - Ginnie Mae), division of Department of Housing and Urban Development. - Farmers Home Administration (FHA)

U.S. Treasury Bills

- Have a maturity of 1 year or less. - They are sold on a discounted yield basis, which simply means they do not pay interest; the bonds just mature at par value.

*Weak Form of the Efficient Market Hypothesis

- Historical information will not help investors achieve above-average market returns. - The weak form holds that security prices reflect all PRICE and VOLUME data. - The weak form REJECTS technical analysis and asserts that fundamental analysis will help an investor achieve above-average returns. - It is in direct contradiction with technical analysis, which attempts to predict future pricing based on the study of past pricing and volume patterns. Summary: - Price reflects: historical price data. - Advantage through: fundamental analysis and inside information. NOTE: all three forms suggest that technical analysis will not help you achieve above-average market returns.

Financial Risk (Unsystematic Risk)**

- How a firm is financed. - The amount of financial leverage deployed by the firm. - Financial leverage is the ratio of debt versus equity the firm has deployed, or the financial structure. - The higher the percentage of debt deployed by the firm, the more risky.

Dividend Discount Model (Important Exam Tips)

- If the required rate of return decreases, the stock price will increase (because there is an inverse relationship between interest rates and prices). - If the dividend is expected to increase, the stock price will increase. - If the required rate of return increases, the stock price will decrease. - If the dividend is expected to decrease, the stock price will decrease. EXAM TIP: know these relationships!

Series I Bonds

- Inflation-indexed bonds that are issued by the U.S. government. I bonds adjust the interest paid for inflation, and therefore, they are seen as a bond that mitigates purchasing power risk. - They do not pay interest periodically, rather, they ACCRUE interest. - I bonds are sold at face value and have no guaranteed rate or return. - The interest portion consists of the following two components: 1. Fixed rate of return. 2. Inflation component that is adjusted every 6 months.

Efficient Market Hypothesis (EMH)

- Investors cannot consistently achieve above-average market returns; therefore, investors should take a passive investment strategy. - Prices reflect all information that is available and change very quickly to new information. - Stock prices will follow a "random walk." - Investors who believe in the efficient market hypothesis believe a PASSIVE investment strategy is appropriate, such as buying and holding an index. - Market anomalies do not support the efficient market hypothesis in any of the three forms.

Collateralized Mortgage Obligation (CMOS)

- Investors in CMOs are divided into "tranches," which determine which investors will receive principal repayment. - Investors are divided into tranches A - Z, which represent short, intermediate, and long-term tranches. - Interest from the pool of mortgages is distributed pro-rata, and the principal repayments are used to retire tranches sequentially. - Investors in the short-term (A) tranche receive principal repayment before the intermediate and long-term tranche (Z). - CMOs are meant to mitigate against prepayment risk associated with mortgage-backed securities.

Guaranteed Investment Contract (GIC)

- Issued by insurance companies with a guaranteed rate of return. - The insurance company agrees to repay the principal and guaranteed rate of return for a period of time. - The yield is higher than treasury securities.

Market Interest Rates

- Market interest rates is the yield that is currently being earned in the marketplace on comparable securities. - Market interest rate is the rate used to discount a bond to determine what it is currently selling for in the market.

Moody's Bond Ratings

- Moody's ratings are Aaa to C - Aaa to Baa are investment-grade bonds - Ba and below are junk bonds

Mortgage Backed Securities (MBS) (Secured Bond)

- Mortgage-backed securities are backed by a pool of mortgages. - Payments consist of both interest and principal. - The biggest risk to the bondholder is prepayment risk.

*Holding Period Return Formula

- Not a compounded rate of return. - There is no consideration for the time an investment was held. Items that make the computation more difficult: - Dividends received: make sure to add them to the numerator. - Margin interest paid: make sure to subtract from the numerator. - Taxes paid: only do this if the question asks for the after-tax gain or loss. The taxes will be computed based on the dividends received and any capital gains on the sale (short-term versus long-term). Taxes, like margin interest, are subtracted from the numerator. - Purchase the securities on margin: in the numerator, make sure to subtract any interest paid. Also, in the numerator, you will include the total cost of the securities as a subtraction from the sales proceeds. In the denominator, you only include your equity in the trade. EXAM TIP: memorize the holding period return (HPR) formula above; it is not provided on the exam. It's possible that HPR questions may come from margin returns or after-tax rate of returns. Another method of calculating the holding period return when provided with periodic returns (instead of cash flows). This is a provided formula. HPR = [(1+r1) x (1+r2) x ... (1+rn)] - 1 r = % return per period n = number of periods

U.S. Treasury Notes

- Notes have a maturity between 2 - 10 years. - Interest is paid semi-annually.

Sharpe Index

- Provides a measure of portfolio performance using a risk-adjusted measure that standardized returns for their variability. The model measures reward to total variability, or total risk. - A risk-adjusted performance indicator. It's also a "relative" risk-adjusted performance indicator, meaning one Sharpe ratio needs to be compared to another Sharpe ratio to provide meaning. - A measure of how much return was achieved for each unit of risk. The higher the Sharpe ratio, the better because that means more return was provided for each unit of risk. - Sharpe Index measures risk premiums of the portfolio relative to the total amount of risk in the portfolio. - The formula does not measure a portfolio manager's performance against that of the market. NOTE: Sharpe uses standard deviation which means that it's best for not well-diversified portfolios. Treynor uses Beta, so it's best for well-diversified portfolios.

*Coefficient of Determination (or R-Squared)

- R-squared is the measure of how much return is due to the market or what percentage of a security's return is due to the market. - Calculate r-squared by squaring the correlation coefficient. I.e., if a mutual fund has a correlation coefficient of 0.8, then its r-squared is 0.64, which means that 64% of the fund's return is due to the market (aka 64% of the fund's return is a function of market variation). R-squared also provides the investor insight into how well-diversified a portfolio is, because the higher the r-squared, the higher percentage of return from the market (systematic risk) and the less from unsystematic risk. With the example above, 64% of the fund is systematic risk, and 36% is unsystematic risk. R-squared also tells the investor if beta is an appropriate measure of risk. - If r-squared is greater than or equal to 0.70, then Beta is an appropriate measure of total risk. - If r-squared is less than 0.70, then Beta is not an appropriate measure of total risk and standard deviation should be used to measure total risk.

*Securities Act of 1933

- Regulates the issuance of new securities (primary market). - Requires that new issues are accompanied by a prospectus before being purchased. Think of it as the PAPER ACT. It deals with the paper of new securities (prospectus, red herring, filing, etc)

*Securities Act of 1934

- Regulates the secondary market and trading of securities. - Created the SEC to enforce compliance with security regulations and laws. Think of it as the PEOPLE ACT. Deals with people in the secondary market. Defines the terms "broker" and "dealer."

US Government Bond Risk

- Reinvestment rate risk - Interest rate risk - Purchasing power risk EXAM TIP: The primary difference between Corporate Bond Risk and US Government Bond Risk is that US government bonds are not subject to default risk. Muni bonds can be considered to have default risk unless they are insured.

Price-to-Earnings Ratio

- Represents how much an investor is willing to pay for each dollar of earnings. It is a measure of the relationship between the stock's price and its earnings. The ratio is a helpful tool used to value a stock if the firm pays no dividends. The relationship of price to earnings is known as the P/E multiplier. P/E = Price per share / EPS OR Price Per Share = P/E x EPS EPS = Earnings Per Share

*Revenue Bonds (Municipal Bonds)

- Revenue bonds are backed by the revenue of a specific project. - Revenue bonds are NOT backed by the full faith, credit, and taxing authority of the entity that issued the bond.

Series EE/Series E Bonds

- Sold at face value, $25 minimum purchase ($10,000 annual maximum) available only through TreasuryDirect (online). - Non-marketable, and non-transferable. - Tied to individual's SSN. - The bonds don't pay interest periodically, but instead, slowly increase in value over 20 years based on a fixed rate at the time of purchase. - They are redeemable after 1 year with a 3-month interest penalty if redeemed in less than 5 years. - The interest is not subject to federal income taxes until the bond is redeemed and may qualify for tax-free treatment if redeemed for education expenses. - Interest is not taxed at the state or local level. EXAM TIP: know that EE Bonds are NOT marketable securities.

Standards & Poor's Bond Ratings

- Standard and Poor's ratings are AAA to D - AAA to BBB are investment quality bonds - BB and below are junk bonds

*Standard Deviation

- Standard deviation is a measure of risk and variability of returns. It is an absolute measure of risk. - The higher the standard deviation, the higher the riskiness of the investment. - In simple terms, it measures how much something flip-flops around an average. In other words, it measures variation of returns around an average. - Can be used to determine the TOTAL RISK of a NON-DIVERSIFIED portfolio. - Total Risk = Systematic + Unsystematic Risk. - Total risk is measured by standard deviation, systematic risk is measured using beta. - The graph below illustrates a normal distribution with probabilities between +/- 1, 2, and 3 standard deviations away from the average. - Understanding what standard deviation around a mean includes: p. 19 of Investment Planning book. - Example of using key strokes: p. 20 of Investment Planning book. EXAM TIP: memorize the 68, 95, and 99% depending on if the return is +/- 1, 2, and 3 standard deviations away from the average. Standard deviation is the appropriate risk measure for non-diversified portfolios, and Beta is used for well-diversified portfolios. See also Measuring Risk Using Data & STD lesson for more info about this.

Subordinated Debentures (Unsecured Corporate Bonds)

- Subordinated debentures have a lower claim on assets than other unsecured debt. - Subordinated debentures have more risk because of the lower claim on assets if the company defaults on the bond repayments.

Treasury Inflation Protected Securities (TIPS)

- TIPS provide inflation and purchasing power protection. - The PRINCIPAL/PAR VALUE adjusts for inflation and, then, the coupon rate is applied to the new principal amount. - The coupon rate DOES NOT change.

*Capital Asset Pricing Model (CAPM)

- The CAPM calculates the relationship of risk and return of an individual security using the Beta as its measure for risk. - CAPM gives us an expected or required rate of return given the riskiness of the asset. - The CAPM formula is often referred to as the Security Market Line (SML) equation because its inputs and results are used to construct the SML. - Assumptions of CAPM: (1) investors should be rewarded for the level of risk that they take on, (2) investors should earn at least the risk-free rate of return, (3) investors should earn a return on the SML. The difference between the (rm - rf) is considered the MARKET RISK PREMIUM, that is how much an investor should be compensated to take on a market portfolio versus a risk-free asset. EXAM TIP: the CAPM formula is on the formula sheet, and you will need to use it! You may be asked to calculate an expected return or required rate of return using the CAPM. Also, you may be given the market risk premium rather than the return of the market. BE SURE TO REMEMBER THAT THE MARKET RISK PREMIUM IS (Rm - Rf).

Price/Earnings to Growth (PEG) Ratio

- The PEG Ratio compared a stock's price-to-earnings ratio to the company's 3-to-5 year growth rate in earnings. - The 3-to-5 year growth rate in earnings is the historical earnings growth rate. - The PEG Ratio is used to determine if the stock's P/E Ratio is keeping pace with the firm's growth rate of earnings. - A PEG ratio of equal to 1 suggests that the stock is fairly valued because the P/E ratio is in line with the earnings growth rate. - A PEG ratio greater than 1 suggests that the stock price is fully valued (or even overvalued) because an expanding P/E ratio is contributing to the stock price appreciating more than the growth rate of earnings.

Arithmetic Average

- The arithmetic average (or mean) is also known as the simple average. - It is the sum of all numbers divided by the number of observations. - The arithmetic mean is a simple calculation. However, when determining the average rate of return of an investment over time, it may give a misleading result. That is because it ignores the compounding effect of returns over time. - See the calculator key strokes on p. 53 of investment planning book.

*Beta

- The beta coefficient is a measure of an individual security's volatility relative to that of the market. In other words, the relationship between a security's return and the market return. - Plotting the security return on the y-axis and market return on the x-axis, Beta is simple the Rise over Run (Rise / Run) or the slope of the line that best represents the security's returns and market returns. - Beta is best used to measure the volatility of a diversified portfolio (one that has a high r-squared). Meanwhile, the standard deviation is an appropriate measure of total risk for a non-diversified portfolio. - It measures SYSTEMATIC risk (or market risk) dependent on the volatility of the security relative to that of the market. Whereas standard deviation is a measure of TOTAL RISK. - The beta of the market is 1. - A stock with a beta of 1 will be expected to mirror the market in terms of direction, return, and fluctuation. - A stock beta higher than 1 means the stock fluctuates more than the market, and greater risk is associated with that particular security. - A stock beta of less than 1 indicates that the security fluctuates less relative to market movements. - The greater the beta coefficient of a given security, the greater the systematic risk associated with that particular security. - Beta can be positive, negative, or zero. Most are positive. - Beta is also a measure of systematic risk or market risk, whereas standard deviation is a measure of the total risk. - Beta is the slope of the line that represents a security's return when plotted relative to market returns. - See formula on p. 25 of Investment Planning book. - Beta may also be calculated by dividing the security risk premium by the market risk premium. Example: - If ABC stock has a Beta of 1.5, and the market is up 10%, what would we expect the return to be of ABC stock? 15%, because a Beta of 1.5 means it's doing 50% better than the market. - If ABC stock has a Beta of 0.5, and the market is up 10%, what would we expect the return to be of ABC stock? 10 x 0.5 = 5%. Also , if it has a Beta of 0.5, that means it's doing half as well as the market. REMEMBER: Standard deviation is the appropriate risk measure for non-diversified portfolios, and Beta is used for well-diversified portfolios.

Yield to Call (YTC)

- The compounded rate of return if an investor buys a bond today and the bond is called (retired) by the issuer. - When calculating YTC, be sure to use the number of periods until the bonds is called, not the time until maturity. - In addition, use the call price, not the par value as the FV. For example: a bond pays 10% ($100 / yr, $50 semiannually), market price is $876, 5-year period to maturity, at which the $1,000 par value will be paid to the investor. END MODE 876 +/-, PV 3 x 2, N 50, PMT 1050, FV I/YR ? = 8.39 x 2 Therefore, I or I/YR = 16.78%

*Dividend Discount Model

- The constant growth dividend discount model values a company's stock by discounting the future stream of cash flows. - This model is also known as The Gordon Growth Model, and the intrinsic value model. - The dividend discount model may be utilized for simplistic perpetual dividend growth rate questions or for more complicated variable dividend growth rates. - The setup for variable dividend growth rates is the same as for a single growth rate, except you must start with the last rate and work backward. - D1 is the next expected dividend. It is calculated using the current dividend and dividend growth rate as follows: D1 = D0(1 + g) NOTE, this is how you calculate the intrinsic value of a stock. EXAM TIP: This formula is in the CFP Exam Formula Sheet. Just be sure to use next year's dividend when determining the value of stock using the constant dividend growth formula.

*Efficient Frontier

- The curve illustrates the best possible returns that could be expected from all possible portfolios. - To determine the efficient frontier, simply compare portfolios based on their risk-return relationship. - The efficient frontier represents the most "efficient" portfolios in terms of the risk-reward relationship. - In other words, the goal is the highest return for an appropriate level of risk. - An investor cannot achieve a portfolio that is a higher return for each level of risk. NOTE, the efficient frontier IS sensitive to input variables.

*Date of Record

- The date on which you must be a registered shareholder in order to receive the dividend. - The date of record is ONE BUSINESS DAY after the ex-dividend date. - An investor must purchase the stock two business days prior to the date of record in order to receive the dividend. - Purchases made on the ex-dividend date will not receive the dividend (ex-date = trades with dividend). EXAM TIP: to receive the dividend, an investor must purchase the stock prior to the ex-dividend date or 2 business days before the date of record.

*Ex-Dividend Date

- The date the stock trades without the dividend. - If you sell the stock on the ex-dividend date, then you will receive the dividend. - If you buy the stock on or after the ex-dividend date, then you will NOT receive the dividend. - The ex-dividend date is ONE BUSINESS DAY before the date of record. EXAM TIP: to receive the dividend, an investor must purchase the stock prior to the ex-dividend date or 2 business days before the date of record (think T + 2, transaction date plus two days to the date of record is the last chance to receive the dividend).

*Internal Rate of Return (IRR)

- The discount rate that sets the NPV formula equal to zero. NPV = PV of Cash Flows - Initial Cost - IRR can also be thought of as a compounded rate of return. - IRR should be calculated when you have uneven cash flows, and you are asked to calculate a compounded rate of return. If NPV is positive, then IRR > Discount Rate If NPV is zero, then IRR = Discount Rate If NPV is negative, then IRR < Discount Rate - An investment is considered acceptable when the IRR equals or exceeds the client's required rate of return. - An investment should be rejected if the IRR is less than the client's required rate of return. - NPV = Present Value of the Future Cash Flows - Cost of the Investment - IRR is the interest rate that will cause the sum of the discounted present value of all the future cash flows to equal the cost of the investment. See calculator keystrokes on p. 59 of investment planning book.

Business Risk (Unsystematic Risk)**

- The inherent risk a company faces by operating in a particular industry. - How variable a firm's operating income is. - For example, Halliburton faces much different risks in the oil industry than Microsoft does, which is primarily selling intellectual property and protecting copyrights.

Length of Time to Maturity

- The length of time to maturity is the time remaining until the bondholder receives the par value. - The length of time to maturity can be described as the "number of periods" to maturity or that the loan will be outstanding. - For a bond paying semiannually, there will be 2 periods per year; quarterly payments will have 4 periods per year; and monthly, there will be 12 periods per year.

*Systematic Risk (Nondiversifiable Risk, Market Risk, Economy-based Risk)

- The lowest level of risk one could expect in a fully diversified portfolio. - It is inherent in the "system" as a result of the unknown element existing in securities to have no guarantees. - Risks that are happening to all companies AT THE SAME TIME. EXAM TIP: Remember PRIME for systematic risks: P: Purchasing Power Risk* R: Reinvestment Rate Risk* I: Interest Rate Risk* M: Market Risk E: Exchange Rate Risk *Most likely to be tested.

*Capital Market Line (CML)

- The macro aspect of the Capital Asset Pricing Model (CAPM). - It specifies the relationship between risk and return in all possible portfolios. - The CML becomes the new Efficient Frontier, mixing in the risk-free asset with a diversified portfolio. - A portfolio's returns should be on the CML. Inefficient portfolios are below the CML. - The CML is not used to evaluate the performance of a single security, only used for well-diversified portfolios. *- Therefore, it uses Standard Deviation as the measure of risk. EXAM TIP: the CML formula is no longer on the formula sheet. You may be asked what measure of risk the CML uses, which is standard deviation. Also, see additional details and graph on p. 36-37 of Investment Planning book.

Market Segmentation Theory (Yield Curve Theory)

- The market is "segmented" into the market for short term funds and long term funds, and the yield curve depends on supply and demand. - The yield curve depends on supply and demand at a given maturity, and there are distinct markets for given maturities with distinct buyers and sellers at each maturity. - When supply is greater than demand at a given maturity, rates are low. Rates will then have to increase for demand to increase. - When demand is greater than supply at a given maturity, rates are high. Rates will then begin to decrease to drive demand down. - Explains both the upward sloping and inverted yield curves.

What are the disadvantages of the dividend discount model?

- The model requires a constant, perpetual growth rate of dividends. - Many stocks do not pay dividends, so the security value may not be estimated with this model. - The growth rate of dividends can't be greater than the expected return, and the security price becomes very sensitive to the expected return when nearing the growth rate.

Separate Trading of Registered Interest and Principal Securities (STRIPS)

- The periodic coupon payments are separated from the bond, and each coupon payment, including the par value, trades separately. - Essentially, treasury STRIPS create zero-coupon bonds. - STRIPS are highly liquid and appropriate for investors looking for a low-risk, highly liquid investment, and with a specific time horizon.

Coupon Rate

- The periodic interest payment received by a bondholder. - The actual dollar amount of the coupon payment is entered as a payment on a financial calculator. For example: A bond with a 10% coupon pays $50 semiannually ($1,000 par x 0.10 coupon divided by 2). That is 10% of the $1,000 par value, paid semi-annually. IMPORTANT CONSIDERATIONS: - The coupon rate, though expressed as an interest rate, is calculated as a constant dollar payment. - Interest rate changes int eh marketplace do not affect the coupon rate payments. - Rising interest rates mean that investors can get a larger stream of cash flows (higher coupon) on new bonds from the corporation. Current bondholders selling bonds must do so at a discount. This makes their bond competitive with the new issues from the corporation. - A drop in market interest rates means coupon rates on new bonds (constant income stream) from corporations will be less than previous bond issues making the older bonds worth a premium. Investors buying these higher coupon bonds (larger stream of cash flows) must pay a premium above par value.

Par Value

- The principal amount is $1,000 on bond issues unless otherwise stated. - The par value is the amount that will be repaid to bond investors at the end of the loan period.

Technical Analysis

- The process of charting and plotting a stock's trading volume and price movements. Analysis of the trading volume and price movements will predict the future direction of stock prices long before fundamental analysis will. - Technical analysis does not involve ratio analysis or analysis of financial statements as fundamental analysis does. - Technical analysts, who conduct technical analysis, believe supply and demand drive stock price. - Resistance may develop when investors who bought on an earlier high may now view this as a chance to get even. Some may see this as an opportunity to take a profit. - Support may develop when a stock goes down to a lower level of trading because investors may choose to act on a purchase opportunity that they previously passed. This is a signal that new demand is coming into the market.

Fundamental Analysis

- The process of conducting ratio analysis on the balance sheet and income statement to determine future financial performance and a forecasted stock price based upon that future financial performance. - Ratio analysis includes calculating liquidity, activity, profitability, and common stock measurements. - Fundamental analysis also includes a look at economic data to determine how the economy will impact various industries. Economic data would include inflation, interest rates, GDP, and unemployment. - Fundamental analysis believes that a stock price performance is largely driven by the financial performance of the firm. - In short, fundamental analysis considers financial statement analysis and economic data. Fundamental analysis assumes: - Investors can determine reliable estimates of a stock's future price behavior. - Some securities may be mispriced, and through fundamental analysis, it can be determined which securities are mispriced.

*Security Market Line (SML)

- The relationship between risk and return as defined by the CAPM and graphically plotted results in the Security Market Line (SML). - Both the CAPM and SML assume an investor should earn a rate of return at least equal to the risk-free rate of return. - This model determines the required rate of return on an asset given its systematic risk. *- The SML uses Beta as its measure of risk, whereas the CML uses Standard Deviation as its measure of risk. - The SML intersects the y-axis at the risk-free rate of return. - If a portfolio provides a return above the SML, it would be considered undervalued and should be purchased. - If a portfolio provides a return below the SML, it would be considered overvalued and should not be purchased. - The SML may also be used with individual securities, not just well-diversified portfolios like the Capital Market Line (CML).

*Dividend Payout Ratio

- The relationship between the amount of earnings paid to shareholders in the form of a dividend, relative to earnings per share. Dividend Payout Ratio = (Common Stock Dividend / EPS) i.e., if the dividend is $3, and the EPS is $5. Then 3/5 = 60%, so this company is paying out 60% of it's earnings in the form of a dividend. So what are they doing with the other 40%? Well, the company is RETAINING it. So... Retention Ratio = 1 - Dividend Payout Ratio - Typically, the higher the dividend payout ratio, the more mature the company. - A high dividend payout ratio may also indicate the possibility of the dividend being reduced. - A low dividend payout ratio may indicate that the dividend may increase, thereby increasing the stock price. *EXAM TIP: this formula is not on the formula sheet, so memorize it.

Portfolio Risk

- The risk of a portfolio can be measured through the determination of the interactivity of the standard deviation and Covariance of securities in the portfolio. - The process also utilizes the weight of both securities involved, the deviations of the respective securities, and the correlation coefficient of the two securities. - The formula is known as the Portfolio Deviation Formula or Standard Deviation of a Two Asset Portfolio. EXAM TIP: the formula is provided on the formulas sheet and is also on p. 27 of the Investment Planning book. Alternatively, you could take a simple (or weighted average) and pick the answer that is lower than the average, to compensate for the correlation between the two assets. See p. 28 in the Investment Planning book for an example of this.

Interest Rate Risk (Systematic Risk)*

- The risk that changes in interest rates will impact the price of both equities and bonds. - There is an inverse relationship between interest rates and both equities and bonds. - When interest rates go up, the present value of bonds goes down.

Reinvestment Rate Risk (Systematic Risk)*

- The risk that the investor will not be able to reinvest at the same rate of return that is currently being received. - I.e., if interest rates go down, we will be reinvesting our money at lower interest rates and therefore receiving lower returns. - Reinvestment rate risk mostly impacts bonds.

*Strong Form of the Efficient Market Hypothesis

- The theory suggests that stock prices reflect all available information and react immediately to any new information. - Asserts that historical, public, and private information will not help investors achieve above-average market returns. - The semi-strong theory REJECTS BOTH technical and fundamental analysis, but inside information will lead to above-average market returns. - Also, the strong theory holds that even with inside information, the market cannot be outperformed on a consistent basis. - So, diversify stocks randomly. - Best for proponents of index funds. Summary: - Price reflects: all information. - Advantage through: None. NOTE: all three forms suggest that technical analysis will not help you achieve above-average market returns.

Risks associated with callable bonds

- The uncertainty about the amount of payments to be made to the bondholders. - The reinvestment risk faced by the bond investor.

Liquidity Preference Theory (Yield Curve Theory)

- The yield curve results in lower yields for shorter maturities because some investors prefer liquidity and are willing to pay for liquidity in the form of lower yields. - The liquidity preference theory also states that long-term yields should be higher than short-term yields because of the added risks associated with longer maturities. The added yield for long-term maturities is meant to compensate investors for the additional risk associated with longer-term maturities. - Only explains an upward sloping yield curve.

Dividend Reinvestment Plan

- They help firms raise new capital. - They give investors a systematic way to accumulate capital. - Companies build goodwill by offering these plans to shareholders.

Jensen's Model/Jensen's Alpha

- Unlike Sharpe and Treynor, Jensen's Alpha is capable of distinguishing a manager's performance relative to that of the market and determining differences between realized or actual returns and required returns as specified by CAPM. - Treynor and Sharpe are calculations for providing a measure and ranking of relative performance. Jensen's model attempts to construct a measure of ABSOLUTE PERFORMANCE on a risk-adjusted basis. -The calculation for alpha is the ACTUAL return of the fund less the EXPECTED return of the fund. An absolute performance measure simply means that looking at Jensen's Alpha tells you something. A POSITIVE Alpha indicates that the fund manager provided MORE return than was expected for the risk undertaken. A NEGATIVE Alpha indicates that the fund manager provides LESS return than was expected for the risk that was undertaken. An Alpha of ZERO indicates that the fund manager provided a return EQUAL to the return that was expected for the risk that was undertaken. NOTE: both Treynor and Alpha use Beta as the measure of risk; therefore, Treynor and Alpha are appropriate risk-adjusted performance indicators when considering a diversified portfolio. A portfolio is considered diversified when r-squared is greater than or equal to 0.70. If the r-squared is less than 0.70, then it is not well diversified and Sharpe should be used because standard deviation is an appropriate measure of risk.

*Accrued Interest

- When purchasing a bond, the buyer pays the seller interest that has accrued since the last interest payment. - The new buyer then receives the full amount of interest due at the next interest payment. - The buyer will receive a 1099-INT that reflects the full periods interest received; however, the buyer is entitled to a deduction equal to the amount of accrued interest paid to the seller. See example on p. 99 of Investment Planning book.

Yield to Maturity (YTM)

- Yield to maturity is essentially the compounded rate of return if an investor buys a bond today and holds it until maturity. - Yield to maturity assumes that an investor is able to reinvest the coupon payment at the yield to maturity rate. - Yield to maturity is useful for comparing the return on different bonds. To calculate use TVM on a calculator (be careful about the frequency of interest being paid i.e. annual or semiannual, and periods of time to maturity which is usually years, but if paid semiannually, needs to be multiplied by 2). For example: a bond pays 10% ($100 / yr, $50 semiannually), market price is $876, 5-year period to maturity, at which the $1,000 par value will be paid to the investor. END MODE 876 +/-, PV 5 x 2, N 50, PMT 100, FV I/YR ? =6.744 x 2 Therefore, I or I/YR = 13.49% EXAM TIP: always assume SEMIANNUAL compounding on the exam, unless told otherwise in the question.

Expected Rate of Return

-See formula (on CFP Exam formula sheet), and can rearrange Dividend Discount Model to get this equation. - Through restructuring of the formula used to calculate value, you can calculate an expected RATE OF RETURN (r). This formula uses "price" (P), that is, market price, in place of value (V) in the calculation. r = (D1/P) + g P = Price (Market Price) D1 = The Next Expected Dividend g = Dividend Growth Rate EXAM TIP: If the required rate of return decreases, the stock price will increase. If the dividend is expected to increase, the stock price will increase. If the required rate of return increases, the stock price will decrease. If the dividend is expected to decrease, the stock price will decrease.

What are the 3 reasons people invest in options?

1. Hedging 2. Speculation 3. Income

*What are the 3 forms of the Efficient Market Hypothesis?

1. Weak Form 2. Semi-Strong Form 3. Strong Form NOTE: all three forms suggest that technical analysis will not help you achieve above-average market returns.

10K and 10Q (Key Document)

10K: An annual report of financial statements filed with the SEC. The 10K is audited. 10Q: A quarterly reported that is filed with the SEC. The 10Q is not audited.

Hannah currently has $915,000 saved. She will retire in 10 years and wants to take $80,000 income for 25 years at the beginning of each year. She also wishes to have $1,000,000 35 years from now to leave to her heirs. What is the internal rate of return needed to accomplish this?

4.96%. Income needs to begin at the beginning of year 10, make end of year 9 the last year of inactivity. The 1,000,000 is entered separately as it is not part of the retirement income stream. If you are struggling with cashflows, please reference the recorded lectures on education and retirement funding methodology. Making a timeline is also very helpful. 10BII and 10BII+ (zeros were truncated to speed up calculation): 915 +/- CFj 0 CFj 9 [Orange Shift] Nj 80 CFj 25 [Orange Shift] Nj 1000 CFj [Orange Shift] IRR/YR

Hannah currently has $715,000 saved. She will retire in 10 years and wants to take $100,000 income for 25 years at the beginning of each year. She also wishes to have $1,000,000 35 years from now to leave to her heirs. What is the internal rate of return needed to accomplish this?

7.09%. Income needs to begin at the beginning of year 10, make end of year 9 the last year of inactivity. The 1,000,000 is entered separately as it is not part of the retirement income stream. If you are struggling with the cashflow methodology, watch the pre-recorded lecture on retirement and education funding methodology. Creating a timeline is helpful also. 10BII and 10BII+ (zeros were truncated to speed up calculation) 715 +/- CFj 0 CFj 9 [Orange Shift] Nj 100 CFj 25 [Orange Shift] Nj 1000 CFj [Orange Shift] IRR/YR

On December 31st Lisa purchased a home with a 20-year mortgage for $150,000 and an 8% compounding interest rate. What is Lisa's principal reduction for the first year?

= $3,171 Step #1: Calculate the monthly payment! N = 20 × 12 = 240 i = 8/12 = .6667 PV = 150,000 PMT = ? FV = 0 PMT = 1,254.66 Step #2: Amortize the loan for the current year On the 10BII+: Enter 1 [INPUT] 12 [Orange shift] [AMORT] [=]

In the Money vs. At the Money vs. Out of the Money

A Call Option is... IN THE MONEY when the Stock Price > Strike Price AT THE MONEY when the Stock Price = Strike Price OUT OF THE MONEY when the Stock Price < Strike Price A Put Option is... IN THE MONEY when the Stock Price < Strike Price AT THE MONEY when the Stock Price = Strike Price OUT OF THE MONEY when the Stock Price > Strike Price

Cash Dividends

A cash dividend is taxed upon receipt. Qualified dividends receive capital gains tax treatment. A qualified dividend: - Is paid by an American company or qualifying foreign company. - Not listed as a dividend that doesn't qualify by IRS. - Held the stock for more than 60 days during the 121-day period that begins 60 days before the ex-dividend date.

Overreaction

A common emotion towards the receipt of news or information.

Confirmation Bias

A commonly used and popular phrase is that "you do not get a second chance at a first impression". People tend to filter information and focus on information supporting their opinions.

Yield Curve

A curve that shows the term structure of interest rates on government debt. In other words, the yield curve demonstrates graphically the relationship between long-term and short-term government debt.

Lognormal Distribution

A lognormal distribution is not a normal distribution. It is appropriate if an investor is considering a DOLLAR AMOUNT or PORTFOLIO VALUE at a point in time. For Example: If an investor invests $1 into the market 60 years ago, it would be worth $60 today. With a lognormal distribution, you are looking for a trend line or ending dollar amount.

Normal Distribution

A normal distribution is appropriate if an investor is considering a range of investment returns.

Red Herring (Key Document)

A preliminary prospectus issued before the SEC approval and is used to determine investors' interest in the security.

Information Ratio

A relative risk-adjusted performance measure. It measures the excess return and the consistency provided by a fund manager, relative to a benchmark. The higher the excess return (or Information Ratio) the better. Excess return can be positive or negative depending on the fund's performance relative to its benchmark. EXAM TIP: on your exam formula sheet!

*Dow Jones Industrial Average Index

A simple price-weighted average (therefore, it does not take into account the percent allocation of the position within the portfolio). The DJIA does not incorporate market capitalization. EXAM TIP: be sure to know the difference between a price-weighted average and a value-weighted index.

Monte Carlo Simulation

A spreadsheet simulation that gives a probabilistic distribution of events occurring. For example, what is the probability of running out of money in retirement with a client who has a withdrawal rate of 3%, 4%, or 5%. Monte Carlo simulation then adjusts assumptions and returns the probability of an event occurring depending upon the assumption. EXAM TIP: It's not likely that the above concepts will be tested. However, understand the characteristics of Monte Carlo simulation. If there is a question, it will most likely be to adjust the assumptions

Strategic Asset Allocation

A strategy that involves assessing the likely outcomes for various allocation mixes between asset classes. Strategic asset allocation is done every few years. Strategic asset allocation is an active allocation strategy. More of a "buy and hold" strategy.

Collar or Zero-Cost Collar

A strategy when the investor owns the underlying stock, but wants to protect the downside risk without paying the entire cost of the put option. An investor sells a call option at a strike price that is slightly higher than the current stock price. This creates a premium received. The investor then buys a put option that is below the current stock price. The premium dollars received by selling the call are used to buy the put option.

Russell 2000 Index

A value-weighted index of the smallest market capitalization stocks in the Russell 3000.

EAFE Index

A value-weighted index that tracks stocks in Europe, Australia, Asia, and the Far East.

*S&P 500 Index

A value-weights index that incorporates market capitalization of individual stocks into the average.

Calculating Bond Duration

A zero-coupon bond will always have a duration equal to its maturity. As the coupon rate increases, the duration decreases. For example: - Bond A: 30-year zero-coupon, duration = 30 - Bond B: 30-year 5% coupon, duration = 27 - Bond C: 30-year 10% coupon, duration = 25 Therefore, as the coupon rate increases, the duration decreases. Alternatively, as the coupon rate decreases, duration increases. As yield to maturity increases, duration decreases. Alternatively, as yield to maturity decreases, duration increases. EXAM TIP: There is a direct relationship between duration and the term of a bond. As the term increases or decreases, duration will increase or decrease. There is an inverse relationship between the coupon rate/yield to maturity and duration. Remember, coupon rate and yield to maturity are INterest rates, and there is an INverse relationship. The IN should help keep it straight. Two methods of calculating duration (see p. 102-103 of investment planning book): 1. Formula from the CFP exam formula sheet. - y = YTM - c = coupon rate - t = # of periods to maturity. 2. PV of Cash flow chart.

If interest on an investment account were to be compounded semiannually, the effective rate of interest will be: A. Higher than the nominal rate. B. Lower than the nominal rate. C. The same as the simple rate. D. Equal to the nominal rate.

A. Higher than the nominal rate. Due to the increased frequency of compounding (semi-annual), the effective rate (or rate paid) will be higher than the nominal (or stated rate) of interest.

Treasury zero coupon bonds are particularly suited to which of the following types of accounts? A. IRA B. Trust C. Corporate D. Joint

A. IRA Zero coupons generate phantom income. Held in an IRA avoids current taxation.

What is the intersection on the y-axis of the CML/SML? A. Risk-free rate of return B. Market portfolio C. Undervalued asset D. Overvalued asset

A. Risk-free rate of return

Which one of the following factors would be the strongest indication that interest rates might rise? A. Selling of dollar-denominated assets by foreign investors. B. Decreasing United States government deficits. C. Decreasing rates of inflation. D. Weak credit demand by the private sector of the United States economy.

A. Selling of dollar-denominated assets by foreign investors. Foreigners selling dollar-denominated assets are preparing to take advantage of higher rates by increasing their liquidity. The rest signal a decrease in rates.

American Depository Receipts (ADRs)

ADRs represent foreign stock held in domestic banks' foreign branches. ADRs entitle the shareholder to dividends and capital gains. Capital gains in ADRs include currency fluctuation. ADRs trade on US exchanges are denominated in U.S. dollars and trade in US dollars. Dividends are paid in US dollars. EXAM TIP: ADRs do NOT eliminate exchange rate risk.

*Federal Agency Securities

Agency bonds are moral obligations of the U.S. government but are not backed by the full faith and credit of the U.S. government. Not backed by the full faith and credit of the US government: - Federal National Mortgage Association (FNMA aka Fannie Mae) - Federal Home Loan Mortgage Corporation (FHLMC aka Freddie Mac) - Student Loan Marketing Association (SLMA aka Sallie Mae) - Federal Farm Credit Banks (FFCB) - Federal Intermediate Credit Banks (FICB) - Federal Home Loan Bank (FHLB) One exception: Government National Mortgage Association (GNMA or Ginnie Mae) bonds are a direct obligation of the government and backed by the full faith and credit of the U.S. government. EXAM TIP: know this card. Agency Bonds are not backed by the full faith and credit of the US government. The one exception to the rule are GNMA bonds which ARE backed by the full faith and credit of the US government.

U.S. Treasury Securities

All U.S. Treasury securities are nontaxable at the state and local levels.

Disposition Effect

Also known as Regret Avoidance or "faulty framing" where normal investors do not mark their stocks to market prices. Investors create mental accounts when they purchase stocks and continue to mark their value to purchase prices even after market prices have changed.

*Original Issue Discount (OID) Bond

An OID bond is issued at a discount from par value. The bond basis increases at a set rate each year. The difference between the maturity value and the original issue discount price is known as the OID. An example of an OID is a zero-coupon bond that is sold at a deep discount to par value. For example, a $1,000 par value zero-coupon bond may sell for $600. The bond will then increase in value over the term of the bond until it matures at par value. For zero-coupon bonds, the bondholder must recognize (or accrete) income each year, even though no interest is received. This is known as imputed or "phantom income" because the bondholder doesn't receive interest until maturity, but still must pay taxes on the increase in value of the zero-coupon bond. If the OID bond is tax-exempt, the bond's earnings are treated as exempt-interest income. Upon maturity, the holder will receive the face value of the bond and no additional income tax will be owed since tax was paid while interest accrued within the security.

Long Straddle

An investor BUYS a put and a call option on the same stock. The investor expects volatility but is unsure as to the direction. For Example: Delta airlines is announcing that it will be purchasing new jet planes for its fleet, and the competition is between Boeing and McDonnell Douglas. One company's stock will increase when they win the contract, the other stock is going down when they lose the contract. An investor would purchase a put and call option on both Boeing and McDonnell Douglas.

Short Straddle

An investor SELLS a put and a call option. The investor DOES NOT expect volatility and is hoping to keep the premiums with little to no volatility in the stock price. Risky income generating strategy.

Options

An option is a derivative security. The value of the option depends on (is derived from) the value of another underlying security. The option contract is an agreement between two parties, the seller (or writer) and the buyer. All transactions are handled through an options clearing house. One option contract controls 100 shares of an underlying security. - One option contract with a premium of $2 will cost $200 ($2 x 100) - Five option contracts with a premium of $4 will cost $2,000 ($4 x 100 x 5)

*Intrinsic Value and Time Premium

An option premium consists of intrinsic value and a time premium. Intrinsic Value (aka how much the stock is in the money): - Call Option: Stock Price - Strike Price - Put Option: Strike Price - Stock Price (intrinsic value cannot be less than 0) Time Value: Time Value = Premium - Intrinsic Value We can rewrite this equation to find the value of an option: Premium = Time Value + Intrinsic value The more time until the option expires, the more time value. **EXAM TIP: critical to remember that the intrinsic value cannot be less than zero.

Hindsight Bias

Another potential bias for an investor. Hindsight is looking back after the fact is known and assuming they can predict the future as readily as they can explain the past.

If Tuesday, June 4 is the date of record, when must Joe purchase the stock in order to receive the dividend? a) June 1 b) June 2 c) June 3 d) May 31

Answer: d) May 31. The stock must be purchased two BUSINESS days prior to the date of record (one BUSINESS day prior to the ex-dividend date). Note this question tricks you by saying the date of record is a Tuesday. So two BUSINESS days prior to that is May 31: 1 biz day = Monday, June 3 Sunday, June 2 - not a biz day Saturday, June 1 - not a biz day 2 biz days = Friday, May 31

Anchoring

Attaching or anchoring one's thoughts to a reference point even though there may be no logical relevance or is not pertinent to the issue in question. Anchoring is also known as conservatism or belief perseverance.

*Put/Call Parity (Option Pricing Model)

Attempts to value a PUT option based on the value of a corresponding call option. EXAM TIP: know this card!

*Binomial Pricing Model (Option Pricing Model)

Attempts to value an option based on the assumption that a stock can only move in one of two directions. For example, over the short term, you have determined that a security, now worth $10, will be either $12 or $8. This model can then be extrapolated further into the future based on the value achieved at each interval. EXAM TIP: explains prices based upon the underlying asset price moving in two directions.

*Investment Company Act of 1940

Authorized the SEC to regulate investment companies. There are 3 types of investment companies: - Open - Closed - Unit Investment Trusts

*B Shares

B shares contain a back-end sales load (redemption fee). They also have high 12b-1 fees, typically the maximum 12b-1 fee of 1%. B shares do not have a front-end sales load. B shares can be converted to A shares. The only advantage is that an investor would not pay the front-load, but they would pay the higher 12b-1 fee until the shares are converted to A shares. Many funds no longer offer B shares.

*Rate Anticipation Swap (Bond Strategy)

Based on forecasts of general interest rate changes.

Bottom-Up vs. Top-Down Analysis

Bottom-up analysts are looking for the next big, but as yet, undiscovered stock that will break onto the scene. Bottom-up analysts start with the company, then the industry, and finally the economic climate. Top-down starts with the economic climate, moves to the industry, and then the company.

Breadth of the Market (Tools of Technicians)

Breadth of the market measures the NUMBER of stocks that increase in value versus the number of stocks that decline in value.

*C Shares

C shares do not charge a front-end load and do not convert to A shares. C shares usually charge a small back-end load and charge the maximum 12b-1 fee of 1%. C shares are usually appropriate for short-term investors.

If the risk-free rate of return is 3% and the beta of a security is 1.5, and the market risk premium is 9%, what is the expected return? A. 13.5% B. 12.5% C. 16.5% D. 12%

C. 16.5%. Note the formula is: ri = rf + B(rm - rf) Another name for rm-rf is the MARKET RISK PREMIUM, which is given to us (in other words, it's not 9-3). ri = 3 + 1.5(9) = 16.5%

A rise in the price of the Japanese Yen in relation to the U.S. Dollar results in: A. A devaluation of the Yen. B. Excess reserves in the U.S. current account. C. A revaluation of the Yen. D. A negative balance of payments.

C. A revaluation of the Yen. Were the Yen to fall in value against the dollar, this would constitute a devaluation, but when it costs more dollars to buy a Yen, this is considered an appreciation or revaluation of the Yen.

Taxation of Options

Call options create two potential tax consequences: 1. If the contract lapses (or expires), then the premium paid is a short-term loss, and the premium received is a short-term gain. 2. If the contract is exercised, the premium is added to the stock price to increase the basis in the underlying stock. If the underlying stock is held for more than 12 months, it will be considered a long-term capital gain or loss. If it's held less than or equal to 12 months, it's considered a short-term gain or loss. For Put Options, if the contract expires without being exercised, the premium paid is a short-term loss, and the premium received is a short-term gain.

Weighted Average

Can be used to calculate a weight average share price, expected returns, beta or duration.

*Closed End Investment Companies

Closed-end funds have a fixed initial market capitalization because a specific number of shares are initially sold to the public. Those shares are then traded on an organized exchange. No new shares are issued by the fund. Shares may trade at a premium or discount to net asset value. Shares of the fund are normally traded in major secondary markets and are actively managed.

Indifference Curves

Constructed using selections made based on this highest level of return given an acceptable level of risk.

Annual Report (Key Document)

Contains a message from the Chairman of the Board on the progress in the past year and the outlook for the coming year. The annual report is sent directly to shareholders.

*What is a Tax Advantage of Preferred Stock?

Corporations receive a 50 or 65% deduction of dividends (preferred and common stock) based on % of ownership of the company paying the dividends (covered in tax) for tax years beginning after December 31, 2017. Corporations benefit most from the tax advantages of preferred stocks. EXAM TIP: know this card!

Education IRA is the same as saying...

Coverdell

The standard deviation of the returns of a portfolio of securities will be _______________ the weighted average of the standard deviation of returns of the individual component securities. A. equal to B. less than C. greater than D. less than or equal to (depending upon the correlation between securities)

D. less than or equal to (depending upon the correlation between securities) Given that the maximum correlation possible is +1, the average deviation of returns of a portfolio can never be greater than that of individual securities. They can be equal to or less than. (Note: Portfolio deviation is NOT a weighted average.)

Affect Heuristic

Deals with judging something, whether it's good or bad. Do they like or dislike some company based on non-financial issues.

Insider Trading and Securities Fraud Enforcement Act of 1988

Defines an insider as anyone with information that is not available to the public. Insiders cannot trade on that information.

Eurodollars (Money Market Securities)

Deposits in foreign banks that are denominated in US dollars.

*Yield Pickup Swap (Bond Strategy)

Designed to change the cash flow of the portfolio by exchanging similar bonds that have different coupon rates.

*Substitution Swap (Bond Strategy)

Designed to take advantage of a perceived yield differential between bonds that are similar with respect to coupons, ratings, maturities, and industry.

No Load Funds

Do not charge a sales commission when purchased or redeemed.

Exchange Traded Funds (ETFs)

ETFs are a portfolio of stock that represents an index. ETFs are traded on an exchange similar to stocks and can be traded intra-day, unlike traditional mutual funds. Investors do not have to buy and sell blindly. ETFs have a low cost of ownership because they are typically passive investments. Most ETFs have no active trading within the fund because the ETF is tracking a stock index. Only when stocks are added or removed from an index is there actually selling assets within an ETF. Most ETFs are tax-efficient investments because of the low asset turnover and passive investment strategies. ETFs are structured to track an index, but they can also be actively managed to track an investment manager's top picks or mimic an existing mutual fund.

*Stock Dividends

Essentially giving more equity to shareholders. Not taxable to the shareholder until the stock is sold. It signals to investors that the firm is retaining capital growth-related activities. The stock dividend is often taken as a favorable signal. It is used for acquisition, increased R&D or occasionally to fend off takeovers. It is more common to see large amounts of debt taken on to make the firm seem less attractive if large amounts of cash are required.

Securities Investors Protection Act of 1970

Established SIPC to protect for losses resulting from brokerage firm failures. It does not protect investors from incompetence or bad investment decisions. It protects account member firms open for clients, regardless of the client's citizenship. Losses are limited to $500k, including $250k of cash.

Investment Policy Statement

Establishes: - A client's objectives - Limitations on the investment manager. It is used to measure the investment manager's performance. The investment policy statement DOES NOT include investment selection. Objectives: - RETURN REQUIREMENT: can be specific to a goal such as education or retirement. - RISK TOLERANCE: clearly defining an investor's risk tolerance is key prior to making any investment selections. Constraints: - Time horizon: when the client anticipates needing the money (for equities to be the best investment for a client, the time horizon will probably be in the 6-7 year range). - Liquidity: coincides with the time horizon. Investment liquidity should be appropriate for the time horizon remaining. - Taxes: whether the account is taxable or nontaxable. - Laws and regs: could be if the assets are held in trust and terms of the trust. - Unique circumstances: anything unique to the client. Exam Tip: The IPS establishes "RR TTLLU": R: Risk R: Return T: Taxes T: Timeline L: Liquidity L: Legal U: Unique circumstances

Marketable U.S. Treasury Issues

Examples include: - U.S. Treasury Bills - U.S. Treasury Notes - U.S. Treasury Bonds All bills, notes and bonds are sold in denominations of $100 or more. Treasury securities are sold on an "auction" basis with the lowest yield winning the auction. REMEMBER, all U.S. Treasury Securities are nontaxable at the state and local level! But they are subject to federal taxation.

Market Anomalies

Exceptions to the rule that markets are truly efficient. In other words, it's a challenge to market efficiency.

Bankers Acceptance (Money Market Securities)

Facilitates imports/exports. They have maturities of 9 months or less and can be held until maturity or traded. Paper traded between banks such as letters of credit to facilitate international trade.

*General Obligation Bonds (Municipal Bonds)

General obligation bonds are backed by the full faith, credit, and taxing authority of the municipality that issued the bond. NOTE: a limited general obligation bond is a bond issued by an entity that has some ability to levy taxes to support itself (for example, a school district). However, this ability is limited when compared to that of the general taxing power of the state. Therefore, it is said to have a restricted revenue base. EXAM TIP: know this card.

Recency

Giving too much weight to recent observations or stimuli; for example, focusing on short-term past performance.

Preferred Stock

Has both equity and debt features. Debt Features: - Stated par value - Stated dividend rate as a percentage of par Equity Features: - Price of preferred stock may move with the price of common stock Differences: - Dividend does not fluctuate like a common stock dividend - No maturity date like a bond - Price of preferred stock is more closely tied to interest rates than common stock The company benefits most from the tax advantage of preferred stock because of the corporate dividend-received deductions based on ownership.

Herd Mentality

Herd mentality is the process of buying what and when others are buying and selling. Herd mentality leads to buying high and selling low.

Money Market Mutual Funds

Highly liquid, appropriate for an emergency fund and invests in securities with maturities of less than 90 days.

Zero-Sum Game

In options trading, when you add together the buyer's and seller's profit, it will equal zero.

Weighted Average Portfolio Return

In the case of a portfolio calculation for the weighted average return, there are several factors that must be taken into account in the process of the calculation: 1. The current FAIR MARKET VALUE of the securities held. 2. The TOTAL PORTFOLIO VALUE (TPV). 3. The RETURN OF EACH SECURITY throughout the period in question. See calculation on p. 56 of investment planning book. See also calculation of Weighted Average Portfolio Beta on the next page.

Secured Bonds

Includes Mortgage Backed Securities (MBS) and Collateral Trust Bonds.

Income Bonds (Unsecured Corporate Bonds)

Income bonds stipulate that interest is only paid when a specific level of income is attained.

Stock Splits

Increases shares outstanding and reduced stock prices. A 2-for-1 split for an investor with 100 shares at $50 per share is... 100 shares x 2 = 200 shares, AT $50 per share / 2 = $25 per share A 3-for-2 split for an investor with 100 shares at $60 per share is... 100 shares x 1.5 [3 / 2] = 150 shares, AT $60 per share / 1.5 [3 / 2] = $40 per share

Alternative Investments

Investments are generally thought of as cash, equities, and bonds. Any asset that is not one of the three traditional asset classes can be considered an alternative investment. Common characteristics include: - Not for the average investor. Typically high-risk investments with large minimum purchase requirements and high fees. - Actively managed, may use leverage to enhance their returns, and invest in illiquid assets. - Liquidity may be limited or nonexistent. There is no secondary market but may offer redemptions at periodic times with advance notice. The most common alternative investments include real estate, REITs, CMOs, and limited partnerships. Other alternative investments and highlights: - Hedge funds: no regulations, self-report, seek positive performance, available to accredited investors only. - Collectibles: fine art, antiques, baseball cards. High risk of fraud, subject to demand and consumer tastes. Net long-term gains from sales of collectibles are subject to a federal income tax rate of 28%. - Precious metals: gold or silver can be purchased directly through exchange-traded funds or futures contracts. Often considered inflation hedges. In other words, gold has a negative correlation to the market and can be used when interest rates are rising as a hedge against inflation. - Cryptocurrency: virtual currency not associated with any particular country or central bank. Units of cryptocurrency are referred to as tokens or coins and can be used for investment purposes or as a form of electronic payment. Many investors believe it acts as an inflation hedge. The amount in existence is limited. Bitcoin, for example, has a maximum of 21 million coins. Not widely accepted as a form of payment. Considered a high-risk investment.

What assumptions does Behavioral Finance make?

Investors are "Normal": Normal investors have normal wants and desires, but may commit cognitive errors (through biases or otherwise). Normal investors may be misled by emotions while they are trying to achieve their wants. Also known as "managing biases." Markets are not Efficient: There can be deviations in price from fundamental value so that there are opportunities to buy at a discount or sell at a premium. As a result, markets can be tough to beat, but they are not efficient. The Behavioral Portfolio Theory Governs: Under this theory, investors segregate their money into various mental accounting layers. This mental process occurs when people "compartmentalize" certain goals to be accomplished in different categories based on risk rather than viewing their entire portfolio as a whole. This may result in having very different risk preferences for the same value depending on the goal or situation. Risk Alone Does Not Determine Returns: The Behavioral Asset Pricing Model determines the expected return of stock using Beta, book-to-market ratios, market capitalization ratios, stock "momentum," the investor's likes or dislikes about the stock or company, social responsibility factors, status factors and more.

What are the 4 basic premises of traditional finance?

Investors are Rational: Investors decisions are logical, centered on a clearly defined goal and free from the unsteady influences of emotion or irrationality, and take into account all available information. Markets are Efficient: At any given time, a stock's share price in the market incorporates and reflects all relevant information about that stock. Stocks are deemed at all times to trade at their fair market value on stock exchanges. The Mean-Variation Portfolio Theory Governs: Mean-variance investors choose portfolios by viewing and evaluating mean returns and variance for their entire portfolios. Returns are Determined by Risk: The CAPM is the basic theory that links return and risk for all assets by combining a risk-free asset with risky assets from an efficient market.

Active Investment Strategy

Investors believe the markets are INEFFICIENT. Investors can achieve above-average market returns through active investing and market timing.

Passive Investment Strategy

Investors believe the markets are efficient, and it's difficult to achieve above-average market returns. A passive buy-and-hold investment strategy is best. Passive investment strategies are buy-and-hold strategies such as laddered bonds, ETFs, barbell bond strategy, UITs, and index investing.

Foreign Currency Translation

Investors may purchase an asset that is denominated in a foreign currency so their return is affected by the growth of the security they purchase and relative growth of the foreign currency and the U.S. Dollar. To solve these problems follow these steps: 1. Convert U.S. dollars to the foreign currency to determine the cost 2. Compute the return, typically utilizing the holding period return calculation 3. Convert the foreign currency back to U.S. dollars

Gambler's Fallacy

Investors often have incorrect understanding of probabilities which can lead to faulty predictions. Investors may sell stock when it has been successful in consecutive trading sessions because they may not believe the stock is going to continue trending upward.

Familiarity Bias

Investors tend to overestimate/underestimate the risk of investments with which they are unfamiliar/familiar.

Growth Mutual Funds

Invests in equities that have a high P/E, little to no dividends and are growing earnings and revenue rapidly.

Growth and Income Mutual Funds

Invests in equity and income-producing assets. The primary objective is to provide capital appreciation and income.

Global Funds

Invests in international and US securities.

Balanced Fund Mutual Funds

Invests in more bonds than a typical equity fund. They seek a well-balanced return in the form of both income and capital appreciation.

Value Fund Mutual Funds

Invests in more undervalued funds that have a low P/E, high dividend yields and positive future outlook

Sector Mutual Funds

Invests in sectors of the U.S. economy such as telecommunications, healthcare, financial services, etc. Sector funds are not well-diversified and have a low r-squared (0.50 - 0.60).

Aggressive Growth Mutual Funds

Invests in small caps and offers the greatest potential for capital appreciation

International Funds

Invests only in international securities and excludes US securities.

Covered Call

Involves selling call options on a stock that is currently owned by the investor. This strategy is appropriate for stock that has been in a trading range, and the investor wants to generate some income but continue to own the stock. This strategy may also be appropriate if an investor is considering selling a stock, but wants to generate some additional premiums dollars and possible get called out of the stock.

Treasury Bills (Money Market Securities)

Issued with varying maturities up to 52 weeks (1 year), a direct obligation of the government. Denominations in $100 increments through Treasury Direct up to $5 million per auction. Larger amounts are available through competitive bids. T-bills have purchasing power risk, but do not have DEFAULT risk.

January Effect (Market Anomalies)

January tends to be a better month because of tax loss selling in November and December followed by investors getting back into the market in January.

Liquidity vs. Marketability

Liquidity: How quickly something can be converted into cash, with little to no price concession. Generally, short-term investment assets are considered liquid. Stocks, bonds, stock mutual funds, and stock bond funds are not considered liquid because an investor could suffer price concessions. Marketability: Exists when there is a ready-made market for something. Real estate is marketable, but not very liquid.

Load Funds

Load funds charge a sales commission when purchased or redeemed. Examples of load funds include A shares, B shares and C shares.

Bob purchased 100 shares of Starbucks trading at $50 per share with an initial margin requirement of 75% and a maintenance margin of 25%. At what price would Bob receive a margin call?

Loan = $50 x (1 - 0.75) = $12.50 per share Price to Receive a Margin Call = $12.50 / (1 - 0.25) = $16.67

Process of Hedging a Position Using a Futures Contract

Long the commodity, Short the contract Short the commodity, long the contract See examples on p. 132

Long Term Equity Anticipation Securities (LEAPS)

Long-term equity anticipation options have longer expiration periods than traditional options. LEAPS have expiration periods that last for two years or more versus traditional options that have expirations up to 9 months. The premiums associated with LEAPS is higher because of the extended time period.

*Prices for bonds that have _______ coupon rates and ____________ durations are more sensitive to interest rate changes.

Lower and longer.

Joe bought Starbucks stock when it was at $50 per share, using 75% initial margin. Within two minutes of Joe's purchase of Starbucks, the price fell to $40 per share. What is Joe's new margin position?

Margin Position = Equity / FMV Margin Position = ($40 - $12.50) / $40 = 68.75% Equity = Stock Price - Loan Equity = $40 - ($50 x 0.25)

Market Risk (Systematic Risk)

Market risk impacts all securities in the short term because the short term ups and downs of the market tend to take all securities in the same direction.

*Return on Equity (ROE)

Measures the overall profitability of a company. There is a direct relationship between ROE, earnings and dividend growth. ROE = (EPS / Stockholders Equity per Share) In other words, ROE = net income (per share) / total equity (per share) *EXAM TIP: this formula is not on the formula sheet, so memorize it.

Repurchase Agreements (Money Market Securities)

Money market securities sold at a discount with an agreement to purchase them back at a higher price later on.

Bond Rating Agencies

Moody's and Standard & Poor's both rate bonds on the company's default risk and investment quality. The higher the bond rating, the lower the yield. The bond rating agencies analyze a firm's: - Liquidity - Total amount of debt - Earnings and stability of those earnings

*Municipal Bonds

Municipal bonds are non-taxable at the federal, state and local level if you live in the issuing state. Bonds issued by territories of the U.S. (Puerto Rico) are not subject to taxes at the federal, state or local levels. There are 3 types of municipal bonds: 1. General Obligation Bonds 2. Revenue Bonds 3. Private Activity Bonds

What is the yield to call of a bond that is selling at $1,200, paying 12% interest, semi-annually, and maturing in 10 years, if the bond is callable in 5 years at $1,050?

N = 5 x 2 I/YR ? PV $1,200 +/- PMT = ($1,000 x 0.12) / 2 = 60 FV = $1,050 = 3.96 x 2 = 7.91%

You own a balanced mutual fund with $600k in stocks and $400k in bonds. The balanced fund returned 9%. The return of the S&P 500 was 15% and the benchmark bond fund returned 5%. Did your balanced mutual fund outperform its benchmark?

No, its return was less than 11% Total portfolio value = $600k + $400k = $1M Therefore, 60% of the portfolio is in stocks (600k/1M), and 40% is in bonds. .6(15%) + .4(5%) = 9% + 2% = 11% is the WEIGHTED AVERAGE. Therefore, because the portfolio did not perform better than 11%, it did not outperform its benchmark.

Non-Marketable U.S. Treasury Issues

Non-marketable securities are not easily bought or sold. Includes Series EE/Series E Bonds, Series HH/Series H Bonds, and Series I Bonds.

Efficient Portfolio

Occurs when an investor's indifference curve is tangent to the efficient frontier.

*Open End Investment Companies

Open-end funds have an UNLIMITED number of shares. As long as an open-end fund receives contributions, the fund family will continue to issue shares. Shares are bought and redeemed directly from the fund family. Shares trade at Net Asset Value (NAV).

Prospectus (Key Document)

Outlines the risks, management team, business operations, fees, and expenses. A prospectus must be issued by an investment company prior to selling shares to an investor.

Private Activity Bonds (Municipal Bonds)

Private activity bonds are used to finance constructions and stadiums. Tax preference items for the Alternative Minimum Tax.

Promissory Note

Private transactions, usually between individuals or between individuals and institutions that create a fixed-income security for the holder. When it is created, the maker (the person borrowing the money) promises to pay the holder of the note the principal amount at maturity, as well as interest on the principal amount in periodic payments, or upon maturity of the note (referred to as a balloon note). While not formally traded on securities exchanges, it is possible to sell an interest in a promissory note if the holder of the note needs liquidity. Promissory notes are commonly used by individuals and businesses who need access to financing but do not have the ability to access that financing from the financial markets.

Bond Fund Mutual Fund

Provides investors with a liquid bond investment that is cost-effective and fairly conservative

Prospect Theory

Provides that people value gains and losses differently and will base their decisions on perceived gains rather than perceived losses. Investors are "loss averse" and have an asymmetric attitude to gains and losses, getting less utility from gaining, say, $100 than they would lose if they lost $100. This explains why investors may avoid higher-risk investments even if they offer strong risk-adjusted returns. It also explains why they overinsure against risks through low deductibles.

Real Estate Investment Trusts (REITs)

REITs are attractive because of the low correlation with the stock market and the diversification benefit that they provide to portfolios. Real estate is a hedge against inflation. REITs must distribute 90% of investment income to shareholders to maintain tax-exempt status. There are 3 types of REITs: 1. Equity REITs: Invest in real estate for capital appreciation. Income is generated from rental income and appreciation. Equity REITs can participate in the appreciation of the underlying properties. 2. Mortgage REITs: Invests mostly in mortgages and construction loans. Make the spread between the lending and borrowing rate. 3. Hybrid: Combo of both equity and mortgage.

Morningstar (Research Reports)

Ranks mutual funds, ETFs, stocks, and bonds using 1 to 5 stars. 1 star represents the lowest ranking. 5 stars represents the highest ranking. EXAM TIP: know that Value Line ranks stocks, and Morningstar ranks primarily mutual funds. Also, know the rankings and whether they are a buy or sell signal.

Value Line (Research Reports)

Ranks stocks on a scale of 1 to 5 for timeliness and safety. A ranking of 1 represents the highest rating for timelines and safety (signal to buy). A ranking of 5 represents their lowest ranking (single to sell). EXAM TIP: know that Value Line ranks stocks, and Morningstar ranks primarily mutual funds. Also, know the rankings and whether they are a buy or sell signal.

*Formulas that you need to know that are NOT provided!

Real Return: [(1 + investment return) / (1 + inflation)] - 1 x 100 Conversion value of a bond: (par / CP) x price of the stock Lowest price before a margin call: loan / (1 - MMR) Coefficient of variation: Standard deviation / average return

Skewness

Refers to a normal distribution curve shifted to the left or right of the mean return. Commodity returns tend to be skewed.

Kurtosis

Refers to variation of returns. If there is little variation of returns, the distribution will have a high peak. Treasuries have little variation of returns, have a high peak, and therefore, have a positive kurtosis. If returns are widely dispersed, the peak of the curve will be low and have a negative kurtosis. EXAM TIP Leptokurtic = High peak and fat tails (higher chance of extreme events). Reflects the tendency of observations to fall closely around the mean creating a peaked distribution at the mean with thicker tails. If historical returns indicate leptokurtosis, then there is much more reserved variation in periodic returns but higher probability of large multi-sigma deviations (i.e. "fat tails"). Platykurtic = Low peak and thin tails (lower chance of extreme events).

*Initial Margin

Reflects the amount of equity an investor must contribute to enter a margin transaction. Can vary based on volatility of the stock (and/or the markets). Regulation T set the initial margin at 50% and was established by the Federal Reserve. The initial margin can be more restrictive based on the volatility of the stock. *NOTE: the entity that establishes the initial margin requirement is the Federal Reserve. EXAM TIP: on the exam, assume 50% margin requirement unless stated otherwise in the question.

*Margin Position

Represents the current equity position of the investor. Margin Position = Equity / FMV Equity = Stock Price - Loan

*Investment Advisers Act of 1940

Required investment advisors to register with the SEC or state.

"Riding the yield curve"

Riding the yield curve refers to the purchase of debt instruments in anticipation of fluctuations in the rates of return on both long and short-term instruments. Rising rates of interest require repositioning a portfolio in advance of the rise in order to avoid significant price drops. These moves are based on anticipated changes in the yield curve.

Joe purchased a bond for $880 with a 9% coupon. He sold the bond after one year when it was paying him a CY of 10%. What is the holding period return?

STEP 1: Calculate the selling price. - Current yield = Coupon Payment / Price of the Bond 0.10 = $90 / Price (Coupon payment = Par value x coupon = $1,000 x 0.09) - Price = $90 / 0.10 = $900 STEP 2: Calculate the Holding Period Return - HPR = (selling price - purchase price +/- cash flows) / Purchase price - ($900 - $880 + $90) / $880 = 12.5%

Short-Selling

Selling first at a higher price, in the hopes of purchasing the stock back at a lower price. The goal is to sell high and buy low. An investor makes a profit when the asset's price decreases in value. Short-selling is the opposite of taking a long position, where the investor anticipates making a profit when the price of the asset increases in value. Investors must have a margin account to protect against any price appreciation of the stock. There is no time limit on how long an investor can maintain a short position. IMPORTANT NOTE: Dividends paid by a corporation must be covered by the short seller.

Commercial Paper (Money Market Securities)

Short-term loans between corporations with maturities of 270 days or less and it does not have to register with the SEC. Commercial paper has denominations of $100,000 and are sold at a discount.

Small Firm Effect (Market Anomalies)

Small cap tends to outperform large cap. It's easier for them to grow revenues and earnings faster than a large cap.

Value Line Effect (Market Anomalies)

Stocks that receive Value Line's highest ranking (1) outperform stocks that receive the lowest ranking (5).

P/E Effect

Stocks with a low price-to-earnings (P/E) ratio tend to outperform stocks with a high P/E ratio.

The Yield Ladder

Study Tip: When shopping, if you see a discount, "Call Mom's Cell Now!" - Discounts (from highest to lowest) is... C: Yield to Call M: Yield to Maturity C: Current Yield N: Nominal Yield

Loss Aversion

Suggests investors prefer avoiding losses more than experiencing gains. An unwillingness to sell a losing investment, in the hopes it will turn around. In other words, investors feel more pain from losses than enjoying the gains.

Systematic vs. Unsystematic Risk

Systematic Risk: - Nondiversifiable risk - Market risk - Economy-based risk Unsystematic Risk: - Diversifiable risk - Unique risk - Company-specific risk

Tactical Asset Allocation

Tactical asset allocation is an active allocation strategy whereby the investor determines expected returns for asset classes, then rebalances the portfolio to take advantage of the expected returns. Tactical asset allocation is performed frequently. Tactical asset allocation is an active management portfolio strategy that rebalances the percentage of assets held in various categories in order to take advantage of market pricing anomalies or strong market sectors.

Weighted Average Share Price

Takes into account the number of shares of each of the various priced securities that are owned.

*Tax-Equivalent vs Tax-Exempt Yield

The "Tax-Equivalent Yield" (T.E.Y) is the yield a taxable corporate bond would need to pay for the yield on a tax-exempt muni to be equivalent to a taxable corporate bond. The "Tax-Exempt Yield" is the after-tax rate of return a taxable corporate bond pays. If the bond is double or triple-tax-free, simply combine the federal, state, and local income tax rates. This is then used for the marginal tax rate. - To be double-tax-free, the bondholder must live in the state that issued the muni bond. - To be triple-tax-free, the bondholder must live in the local municipality that issued the bond. Tax Equivalent Yield (TEY) = Tax Exempt Yield / (1 - Marginal Tax Rate) OR TEY = r / (1 - t) r = tax exempt yield t = marginal tax rate **NOTE: use the taxes you save in the equation. I.e., if the question is asking for the TEY of a treasury security, use the state income tax rate since treasuries are not taxed at the state and local level. If the question asks for the TEY of a muni bond, use the marginal federal tax rate since they are not taxed at the federal level. We can restate the formula: Tax-Exempt Yield = (Corporate Rate) x (1 - Marginal Tax Rate) This formula is not provided on the formula sheet but is the algebraic equivalent to the TEY formula provided. If a muni bond is exempt from federal and state taxes, the effective state tax rate must be considered. The effective tax rate takes into consideration that state income taxes are deductible at the federal level. The formula to determine the taxable equivalent yield for a double-tax-free bond is: T.E.Y. Both Federal and State Taxes = Tax-Exempt Yield / (1 - [Federal Tax Rate + State Tax Rate(1 - Federal Tax Rate)]) NOTE: only use the above formula if the client itemizes deductions on his tax return. Otherwise, just add the federal and state tax rates and use the taxable equivalent yield formula.

*Black/Scholes (Option Pricing Model)

The Black Scholes Model is used to determine the value of a CALL option (NOT a put option). The model considers the following variables: - Current price of the underlying asset - Time until expiration - The risk-free rate of return - Volatility of the underlying asset All variables have a DIRECT relationship to the price of the option, EXCEPT THE STRIKE PRICE. As the strike price increases, the option decreases in value. EXAM TIP: know the variables considered in Black Scholes. REMEMBER InVEST: In - risk free rate V - volatility E - exercise (strike) price S - stock price T - time You can remember that the strike price is inversely related to the option price by writing the "E" in the acronym above backwards.

The Dow Theory (Tools of Technicians)

The Dow Theory signals an end to a bull or bear market. It does not indicate when it will happen, it just confirms that it has ended.

Which index uses the geometric average to compute its daily value?

The Value Line Average (aka Value Line Composite Index). The NASDAQ, the NYSE Composite, and the Wilshire all use value weighted average, while the Dow Jones Industrial is a simple price weighted average.

Advance Decline Line (Tools of Technicians)

The advance decline line is the difference between the number of stocks that closed up versus the number of stocks that decreased in value.

Coupon Rate (CR) or Nominal Yield

The annual payment amount in dollars, divided by the par value

Wiltshire 5000 Index

The broadest index that measures the performance of over 3,000 stocks. The last time the Wilshire 5000 actually contained 5000 or more stocks was December 2005. The Wilshire 5000 is also a value-weighted index.

Herding

The cognitive bias is explained just by looking at the word. People tend to follow the masses or the "herd."

Current Yield (CY)

The current yield is the annual payment amount in dollars divided by the current price of the bond.

*Dividend Yield Formula

The dividend yield formula states the annual dividend as a percentage of the stock price. Dividend Yield = Dividend / Stock Price EXAM TIP: this is not on the formula sheet, so make sure you memorize it.

Assume the following dividends will be paid in the coming years: Year 1: $2.00 Year 2: $2.50 Year 3: $3.00 After the third year, the dividend will grow at 8%, and the investor's required rate of return is 10%. What is the intrinsic value of the stock?

The easiest way to start is to draw a timeline. Year 0 - zero cash flows Year 1 - $2.00 Year 2 - $2.50 Year 3 - $3.00 Does she have constant dividend growth between Year 0 and Year 3? No, as it says, the dividend isn't consistently growing until Year 3, so let's do dividend discount model for Year 3. V3 = D4 / (r - g) aka D3(1 + g) / (r-g) V3 = 3.00(1 + .08) / .1 - .08 V3 = $162 -- this represents the intrinsic value of the asset at time value 3. So we have to discount it back to time value zero to find the intrinsic value. But note, we have to account for the additional cash flow at Y3 of $3.00 in our calculation. 0 CFj 2 CFj 2.5 CFj 165 CFj (aka the $162 intrinsic value at Y3 + the dividend at Y3) 10 I/YR OS NPV = $127.85

The current annual dividend of ABC Corporate is $2.00 per share. Five years ago, the dividend was $1.36 per share. The firm expects dividends to grow in the future at the same compounded annual rate as they grew during the past five years. The required rate of return on the firm's common stock is 12%. The expected return on the market portfolio is 14%. What is the value of a share of common stock of ABC corporation using the constant dividend growth model? A. $11 B. $17 C. $25 D. $54

The first step is calculating the growth rate, since it is not given. However, they gave us the value of the stock today and five years ago. So we can do a TVM calculation to find the growth rate (g). PV = <1.36> FV = 2 n = 5 i = ? = 8.0185% = ~8% To solve this problem, we use the dividend discount model (aka constant dividend growth model): V = D1 / (r - g) We solve for D1 = D0(1 + g) = 2(1 + .08) = $2.16 Now we plug and solve: V = D1 / (r - g) V = 2.16 / .12 - .08 V = $54

*Insured Municipal Bonds

The following companies insure municipal bonds: - American Municipal Bond Assurance Corp. (AMBAC) - Municipal Bond Insurance Association Corp. (MBIA) If an insured municipal bond is in default, the insurance company will pay the interest and principal amounts.

*At what price does an investor receive a margin call price?

The formula below is used to determine the price that the investor will receive a margin call. Margin Call = (Loan) / (1 - Maintenance Margin) EXAM TIP: This formula is NOT on the exam formula sheet, so memorize it!

Effective Annual Rate Formula

The formula calculates the effective annual interest rate earned on an investment when the compounding occurs more often than once per year. r = stated annual interest rate m = number of compounding periods Can also use TVM calculation if given % return and original investment amount. N = 1 (if compounded annually, 1x2 if compounded semi-annually, 1x4 if compounded quarterly, etc.) I/YR = % return provided (divide it by 2 if compounded semi-annually) PV = the original investment amount (remember this should be a negative amount because you are putting money in) PMT = 0 FV = ? EXAM TIP: Earning 10% compounded quarterly is equivalent to earning 10.38% compounded annually. EAR = (1 + .10/4)^4 - 1 EAR = (1 + .025)^4 - 1 EAR = (1.025)^4 - 1 EAR = 1.1038 - 1 = .1038 = 10.38%

Stop-Limit or Stop-Loss Limit Order

The investor sets two prices: - The first price is the stop-loss price; once the price is reached the order turns to a limit order. - The second price is the limit price. An investor will not sell below the second price. The risk is that if the market moves quickly, the order may not fill, and the investor may be left with the stock at a significantly lower price. A stop-loss limit order is appropriate for investors with significant gain built into the stock but may not want to sell the stock during a period of significant volatility based on short-term news.

Covariance

The measure of two securities combined and their interactive risk. In other words, how price movements between two securities are related to each other. It is a measure of relative risk. If the correlation coefficient is known, or a given, covariance is calculated as the deviation of investment 'A' times the deviation of investment 'B' times the correlation of investment 'A' to investment 'B'. EXAM TIP: you may need to calculate COV if you are given the correlation coefficient and need to calculate the standard deviation of a two-asset portfolio. This is a provided formula on the CFP Board formula sheet. Also, see formula on p. 24 of Investment Planning book.

*Maintenance Margin

The minimum amount of equity required before a margin call.

Neglected firm effect

The neglected firm effect is the market anomaly phenomenon of lesser-known firms producing abnormally high returns on their stocks. The companies that are followed by fewer analysts will earn higher returns on average than companies that are followed by many analysts.

Short Interest (Tools of Technicians)

The number of shares sold short gives insight into the future demand for a stock. Stock that was sold short eventually needs to be purchased. A high short interest indicates "pent up" demand.

Optimal Portfolio

The one selected from all efficient portfolios. An indifference curve represents how much return an investor needs to take on risk. If an investor is risk averse, this investor will have a very steep indifference curve. This means the investor requires significantly more return to take on just a little more risk. If the investor is risk-seeking, they will have a relatively flat indifference curve. This means the investor will not require a significant amount of return to take on more risk. The point at which an investor's indifference curve is tangent to the efficient frontier, represents that investor's optimal portfolio. See graphs on p. 35 of Investment Planning book. If someone is risk averse, they have steep indifference curves. If someone is risk-seeking, they have flat indifference curves.

Limit Order (Type of Order)

The price at which the trade is executed is more important than timing. A limit order is most appropriate for stocks that are extremely volatile and not frequently traded.

Stop Order (Type of Order)

The price hits a certain level and turns into a market order. A stop order to sell means that once the stop order is reached, the stock is sold at the price or possibly less because it has become a market order. The primary risk is that the investor may receive significantly less than anticipated if the market is moving too quickly.

What is the difference between the primary, secondary, third and fourth market?

The primary market is where investment bankers and corporations meet to arrange offerings to the public. The secondary markets are where previously issued securities are sold (exchanges, etc.). The third market is the trading of exchange-listed securities in the over-the-counter market. These trades allow institutional investors to trade blocks of securities directly rather than through an exchange, providing liquidity and anonymity to buyers. The fourth market is the market where corporation and institutional investors deal directly with one another. It is therefore where exchange and B/D services are eliminated entirely.

Mean Variance Optimization

The process of adding risky securities to a portfolio, but keeping the expected return the same. It's finding the balance of combining asset classes that provide the lowest variance as measured by standard deviation.

Naive Diversification

The process of investing in every option available to the investor. Also known as 1/n diversification. This is common with 401(k) or other retirement-sponsored retirement plans. A plan participant thinks they are adequately diversified if they invest in an equal amount in all the funds.

Inflation-Adjusted Rate of Return

The real rate of return or the inflation-adjusted rate of return is appropriate to use when there are two items occurring simultaneously. 1) You have an investment growing at one rate of return, AND 2) You have an expense growing at a different rate of return. Real Rate of Return = [(1 + Rn)/(1 + Ri)] - 1 x 100 EXAM TIP: You will need to know this calculation, it is not provided.

Country Risks (Unsystematic Risk)**

The risk a company faces by doing business in a particular country. For example, Halliburton faces unique risks doing business in Iraq.

Accounting Risk (Unsystematic Risk)

The risk associated with an audit firm being too closely tied to the management of a company. For example: Arthur Andersen and Enron.

Executive Risk (Unsystematic Risk)

The risk associated with the moral and ethical character of the management running the company.

Default Risk (Unsystematic Risk)**

The risk of a company defaulting on their debt payments. Default risk can be thought of as the likelihood of a firm being able to satisfy its debt obligations on time.

Purchasing Power Risk (Systematic Risk)*

The risk that (1) inflation will erode the amount of goods and services that can be purchased, and (2) a dollar today cannot purchase the same amount of goods and services tomorrow or the day after. Purchasing power risk impacts both equities and bonds.

Exchange Rate Risk (Systematic Risk)

The risk that a change in exchange rates will impact the price of international securities.

*Unsystematic Risk (Diversifiable Risk, Unique Risk, Company-specific Risk)

The risk that exists in a specific firm or investment that can be eliminated through diversification. Through ownership of a number of different securities or investments, the investor can eliminate this risk and insulate their investments. EXAM TIP: Unsystematic risks are ABCDEFG: A: Accounting Risk B: Business Risk** C: Country Risk** D: Default Risk** E: Executive Risk F: Financial Risk** G: Government/Regulation Risk** **Most likely to be tested.

Government/Regulation Risk (Unsystematic Risk)**

The risk that tariffs or restrictions may be placed on an industry or firm that may impact the firm's ability to effectively compete in an industry.

Illusion of Control Bias

The tendency for people to overestimate their ability to control events; for example, it occurs when someone feels a sense of control over outcomes that they demonstrably do not influence.

Cognitive Dissonance

The tendency to misinterpret information that is contrary to an existing opinion or only pay attention to information that supports an existing opinion.

Unbiased Expectations Theory (UET) (Yield Curve Theory)

The unbiased expectations theory is related to the term structure of interest rates. The theory holds that today's longer-term interest rates have embedded in them expectations about future short-term interest rates. More specifically, long-term rates are geometric averages of current and expected future shorter-term interest rates. See example on p. 101 of investment planning book for further clarification. NOTE: this is a CFP Board provided formula.

Best Efforts Underwriting

The underwriter agrees to sell as much of the offering as possible. The risk of the issue not selling resides with the firm because any shares not sold to the public are returned to the company.

Expectations Theory (Yield Curve Theory)

The yield curve reflects investors' inflation expectations. Typically, since investors are undertaken or believe inflation will be higher in the future, long-term yields are higher than short-term yields. Whenever inflation is expected to be lower in the future, long-term rates will be lower than short-term rates, resulting in an inverted yield curve.

Types of investment Companies

There are 3 types of investment companies: - Closed End - Open End - Unit Investment Trust (UIT)

*Bearer Bonds

These bonds are considered to be owned by whoever possesses them.

*What are the important differences between futures and options contracts?

They are both derivatives, however... 1. Options contracts give the holder the RIGHT to buy something; futures contracts OBLIGATE the holder to make or take delivery of the underlying asset. 2. Futures contracts do NOT state the per unit price of the underlying asset, which is determined by supply and demand. EXAM TIP: know the differences between futures and option contracts!

Representativeness

Thinking a good company is a good investment without regard to an analysis of the investment.

Geometric Average

This is the standard formula for finding the geometric mean for a set of observations, where a1, a2, a3, etc. may represent a set of given stock prices over a period of time. The geometric average, or geometric mean, is also a time-weighted compounded rate of return. See formula on p. 53 of investment planning book, and see the calculator keystrokes on p. 54. It is also provided on the formula sheet!

Married Put

This strategy involves buying a put option on a stock or index that is currently owned by the investor. This strategy could also be called "portfolio insurance" if the investor owns a diversified portfolio of common stocks. EXAM TIP: when asked a question about "protecting profits" or "locking in gains," the right answer is always buying a put. This is true whether it is a put on a single stock or an index to protect a diversified portfolio of common stocks.

Random Walk Theory

This theory states that: - The behavior of stock prices closely resembles a random walk. - Prices of stocks are "unpredictable" but not "arbitrary." - It's impossible to consistently achieve above-average market returns. - At any given moment, prices that exist on securities are the best incorporation of all available information and a true reflection of the value of that security. - Prices are in equilibrium. - Changes in price and volume of trading are generated by changing needs of investors.

Certificates of Deposit (Money Market Security)

Time deposit at a bank with a set interest rate and maturity date.

Market Order (Type of Order)

Timing and speed of execution are more important than price. A market order is most appropriate for stocks that are not thinly traded.

How to Calculate Gain or Loss Using Options

To determine the gain or loss of an option, consider two components: 1. The intrinsic value of the option, and 2. The premium paid or received Use the mnemonic "STOPS" to calculate the total gain or loss of an option position: St: Stock gain or loss - if you own the underlying stock O: Options gain or loss P: Premium paid or received S: Shares controlled or owned See p. 124 of Investment Planning book for example of selling a call/put option.

Index Mutual Funds

Tracks the performance of various market indices. Index funds are a PASSIVE investment strategy. They are also TAX EFFICIENT because they have low turnover rates, which therefore minimize capital gains distributions. Stocks are not frequently added or removed from an index, which leads to low turnover and infrequent capital gains distributions.

Odd Lot Trading (Tools of Technicians)

Trades for less than 100 shares. Most odd lot trading is done by small investors. Odd lot trading is a contrarian indicator that assets small investors are most likely wrong regarding their trades, so, do the opposite of the individual investors.

*Unit Investment Trusts

Unit investment trusts are self-liquidating, have passive management, and no trading of assets within the trust. They can be an equity or fixed income unit investment trust, but are typically fixed income. They are managed by a trustee, not an investment manager. *A unit investment trust issued "units," not shares. Units can then be sold back to the UIT at NAV (there is a very thinly traded secondary market). Additional securities are not added to the trust. EXAM TIP: know that UITs are passively managed and self-liquidating.

*Net Present Value (NPV)

Used to evaluate capital expenditures that will result in differing cash flows over the useful life or investment period. NPV is deterministic. - If the NPV is positive, the investor would make the investment. - If the NPV is negative, the investor would not make the investment. NPV = PV of Cash Flows - Initial Cost EXAM TIP: if NPV = 0, then YES, make the investment. See calculator keystrokes on p. 58 of investment planning book.

Similarity Heuristic

Used when a decision or judgment is made when an apparently similar situation occurs even though the situations may have very different outcomes.

Overconfidence Bias

Usually concerns an investor that listens mostly to himself or herself, overconfident investors often rely on their skills and capabilities to do their own homework or make their own decisions. This effect causes many investors to overstate their risk tolerance. Also, overconfidence leads to overtrading.

Warrants

Warrants are essentially long-term call options issued by the corporation. Call options are written by investors. The expiration period is much longer than options, usually 5 - 10 years. Call options have expiration periods of 9 months or less. Warrant terms are NOT standardized. Call options contracts are standardized in terms of the expiration month and number of shares controlled. EXAM TIP: know the differences between call options and warrants!

Asset Allocation Funds or Lifecycle Funds

Well-diversified portfolios including stock, fixed income, international and money market securities. As market conditions change, or as the investor gets closer to her retirement goal, the asset allocation changes.

Availability Heuristic

When a decision maker relies upon knowledge that is readily available in his or her memory, the cognitive heuristic known as "availability" is invoked. This may cause investors to overweight recent events or patterns while paying little attention to longer-term trends.

*How much equity must an investor contribute?

When a stock price falls below the stock price at which an investor will receive a margin call, the investor will receive a margin call and must contribute equity to restore their equity position. For the purposes of the exam, an investor must restore their equity position to the maintenance margin.

Bounded Rationality

When individuals make decisions, their rationality is limited by the available information, the tractability of the decision problem, the cognitive limitations of their minds, and the time available to make the decision. Decision-makers in this view act as "satisfiers", seeking a satisfactory solution rather than an optimal one. One consequence of this concept is that having additional information does not lead to an improvement in decision-making due to the inability of investors to consider significant amounts of information.